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(Bloomberg) — Credit markets are breathing a sigh of relief after inflation data showed price pressures are cooling broadly, but a weakening economy poses fresh risks to corporate debt. 

A perceived gauge of risk in the high-yield credit market eased to the lowest since March following cooler-than-expected inflation in June. But the optimism may be masking risks that would materialize if the Federal Reserve doesn’t manage to pull off a soft landing and the economy cools too much, potentially pushing credit downgrade and default rates higher.

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“For the first time in this post-Covid cycle we are seeing concurrent softness across a bunch of different variables,” Vishwas Patkar, a strategist at Morgan Stanley, said in a phone interview. “We don’t want to see the economy slow too much further from here. If growth is too weak, you start to worry about fundamentals, defaults and downgrades.” 

For those bearish on the economy, there’s been a slew of signals that point to emerging weakness. Hiring and wage growth eased in June, the jobless rate rose to the highest since late 2021 and services activity contracted at the fastest pace in four years. The consensus among economic forecasters is that there’s a 30% chance of a recession in the next 12 months.  

“Inflation is no longer the only risk we face,” said EY Chief Economist Gregory Daco. “Maintaining excessively restrictive monetary policy when the labor market appears to be fully back in balance could lead to an undesired weakening of employment growth and the economy.”

Credit investors are, so far, brushing off the risks, instead piling into a deluge of debt sales to capture some of the highest yields in a decade. Risk premiums in both the high-yield and investment-grade bond markets are tight as demand continues to outpace supply. Money managers are also moving up the risk curve, according to data compiled by LSEG Lipper, pulling money from blue chip funds and adding $675.5 million to junk ones.

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Still, “correlations between equities and credit are breaking down because higher-for-longer interest rates has been a negative for a large number of equities but supportive of credit in general because of yield-seeking investors,” Priya Misra, a portfolio manager at JPMorgan Asset Management, said by phone.

Morgan Stanley remains constructive on credit and a more severe US downturn is not its base case, though it is a downside risk, Patkar said. Other investors are rotating out of the US after credit’s strong run this year. Amundi SA, for example, prefers Europe at the moment on valuations, according to a note from the asset manager on Friday.

For some investors, the recent string of US data offers a welcome refocus on the growth outlook. 

“Major milestones for the Fed are all behind us,” said Jeff Klingelhofer, co-head of investments at Thornburg Investment Management following the most recent labor and inflation data. “We can finally move on from incessant chatter about the Fed and return our focus to what really matters: the underlying economy.”

Week in Review

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• Leveraged finance bankers are eyeing a potential revival in mergers and acquisitions in the second half of the year to boost sales of risky debt that fund the deals. They may be left waiting as risks including the US election keep a lid on buyout activity.
  • Banks have postponed at least three leveraged loan repricing deals in recent weeks, a sign that the European credit market’s appetite for risk has limits.
• US company pensions are poised to shift billions of dollars into corporate credit, after months of stock-market gains and higher bond yields have left them awash with cash, analysts and advisers said.
• GAM Holding AG and M&G Investments are among investors in global Additional Tier 1 bonds now taking profits after a historic rally in the junior bank debt.
• The global artificial intelligence frenzy is driving demand for energy-intensive data centers, which could end up being a factor that boosts sales of green debt in the US, according to Morgan Stanley.
• Loose bond documentation that flourished in the easy-money era has left investors vulnerable to asset stripping in recent debt deals. Now they’re fighting back.
• Jefferies Financial Group Inc. is winding down trading positions at its hedge fund 352 Capital, after the fund sued its former portfolio manager over an alleged fraud.
• Broadcom Inc. borrowed $5 billion in the US investment-grade bond market to refinance a portion of the loans it secured to pay for its $69 billion acquisition of VMware Inc.
• Barclays is floating a 9% yield on a $350 million high-yield bond offering to support Apollo’s buyout of US Silica.
• BNP Paribas SA is reaching out to potential investors for a significant risk transfer linked to a corporate loan portfolio.
• Investors are being insufficiently compensated for the risks of lending in the credit market as more capital chasing too few opportunities curbs returns, according to Pacific Investment Management Co.
• The bankrupt estate of Purdue Pharma says it will support a move by the opioid maker’s creditors to sue members of the Sackler family over allegations that they improperly shifted billions of dollars of Purdue profits into offshore trusts.

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On the Move

• Blackstone Inc. has hired Tyler Dickson, former global head of investment banking at Citigroup Inc., to lead client relations for its credit and insurance unit.
• Societe Generale SA has recruited Joseph Falcone to lead its private credit partnership with Brookfield Asset Management.
• Nuveen Asset Management LLC is growing its credit team in London and plans to create a new European leveraged finance team.
• Johannes Bolzano, who works in Pimco’s private strategies team, is leaving the firm to join London-based hedge fund Alinor Capital Management.
• Alantra Partners SA has recruited Jeremy Hermant to help develop its UK-focused business in so-called significant risk transfers.
• Rothschild & Co. has hired senior bankers Brandon Aebersold and Parry Sorensen from Lazard Inc. as it deepens its push into the US restructuring business.
• Jim Leaviss, the head of fixed income at M&G Investments and creator of the popular Bond Vigilantes blog, is exiting the firm after a 27-year career to pursue a master’s degree in art history.
• Apollo Global Management Inc. has hired Kazuo Yamataka to focus on its private credit strategy in Japan.
• Pimco is ramping up its expansion into private markets by adding a portfolio manager, Prashant Dwivedi, in the Asia-Pacific region.
• Bank of America Corp. has appointed Ryo Minoo as Asia Pacific head of the fixed income, currencies, and commodities electronic trading sales team.

—With assistance from Hannah Benjamin-Cook, Tasos Vossos and James Crombie.

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