The CCC spread in Europe is normally very highly correlated with the CCC spread in the US. But this relationship has changed after the Fed started raising rates, see the first chart below.
Spreads are currently pricing that Europe will have a recession with many defaults, but in the US, everything is fine.
The rally in the US relative to the EU has happened despite the consensus seeing a 60% probability of a recession in the US over the next 12 months and only a 50% probability in Europe, see the second chart.
The bottom line is that there is an inconsistency in pricing of lower-rated corporate credit in the US and Europe. We cannot both have that everything is fine and at the same time we are going into a recession.
The key question is why US credit has rallied so much despite the high recession probability. Given the relationship changed after the Fed started raising rates maybe the reason is what could be called a yield level illusion in US lower-rated credit, where investors focus more on the levels of yields than on the underlying fundamental credit risks of Fed hikes and permanently higher costs of capital.
In short, credit investors today should be asking themselves if spreads are focusing on yield levels or on credit fundamentals.
Source: Bloomberg, Apollo Chief EconomistSource: Bloomberg, Apollo Chief Economist
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