“The more you think, the more pessimistic you become”! Goldman Sachs: The "next shoe" in the credit market is dropping.

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Goldman Sachs' credit strategy team has issued a rare pessimistic warning, saying that the pressure in the current capital markets is far from being released, and their latest report is directly titled "The More We Think, The More Pessimistic We Get".

Under the combined pressures of ongoing energy price shocks, high financing costs, and still tight credit spreads, the team maintains a significantly underweight stance, specifically naming AT1 bonds, investment-grade corporate hybrid bonds, and BB-rated high-yield bonds as the next batch of assets likely to be sold off.

In their latest report, the team led by Goldman Sachs credit strategist Abel Elizalde stated that their model portfolio is currently at a 78% underweight position, with a beta of -0.6. The team believes the probability of sustained energy price disruptions is rising, and the resulting macro scenario is "not optimistic"; meanwhile, credit spreads relative to the current economic fundamentals are still tight. If capital outflows accelerate, technical factors may quickly reverse.

Regarding market impact, Goldman Sachs warns that last week credit markets widened across the board, but implied volatility lagged behind the credit default swap index, indicating investors have flocked into more liquid macro hedging instruments. The team suggests traders start selling credit volatility at current levels, reasoning that the market is shifting from a "shock-driven" rapid pricing phase to a "economic-impact-driven" slow pricing phase, but still maintains a bearish direction.

High Financing Costs Threaten Corporate Interest Coverage Ratios

Goldman Sachs points out that corporate bond coupon rates have risen to a ten-year high, and since yields remain above coupons, financing costs are set to climb even further.

The more critical issue is that companies widely based their financial planning on expectations of rate cuts. If the scenario of "higher for longer" rates comes true, interest coverage ratios will fall into dangerous territory, forcing companies to take contractionary actions—cutting debt, curtailing investments, and reducing costs.

The team believes that based on the current economic and fundamental conditions, the fair value of the European crossover credit index (Xover) should be around 325 basis points, still wider than current levels. If energy disruptions persist, the economy and fundamentals will further deteriorate, and fair value will not narrow—"this does not make us optimistic".

AT1, Hybrid Bonds, BB-Rated Bonds: The Next "Shoes"

Goldman Sachs lists AT1 bonds, investment-grade corporate hybrid bonds, and BB-rated high-yield bonds as candidates for the "next shoe to drop".

The report notes that investors have piled into these assets over the past two years in pursuit of beta returns, resulting in extremely tight spreads. As these assets are relatively liquid, they are likely to be the first to be sold off if market sentiment reverses.

The team suggests shorting these assets, using underperforming types in the iTraxx index as hedging targets, such as senior mezz tranches.

Specifically, investors holding hybrid bond long positions may consider shifting to the 6%-12% tranche on the iTraxx main index; investors holding BB-rated bonds or AT1 longs may shift to the 20%-35% tranche on Xover.

Energy Shocks and Constrained Policy Space Make Macroeconomic Outlook Complex

Goldman Sachs believes current geopolitical tensions are more likely to escalate than ease, with lingering risks of high energy prices. At the same time, the European inflation breakeven rate has jumped from 1.75% to around 3% in two weeks, and this rapid repricing of inflation expectations has severely limited central banks' policy options.

The report especially emphasizes that current ten-year interest rate levels are much higher than at the start of the inflation surge in 2022, making coordinated monetary and fiscal responses less flexible than anticipated.

If central banks hike rates too rapidly to compensate for earlier misjudgments about "transitory inflation," it will deal a significant blow to economic growth and may pressure governments to boost fiscal stimulus, leading to higher long-term rates and forming a vicious cycle.

"The more you think, the deeper you fall into a pessimistic rabbit hole," the report writes.

Goldman Sachs states that it will closely monitor money supply growth, bank credit growth, and net credit market supply to assess changes in private sector credit demand.

The team concludes that the market is transitioning from a shock-driven pricing phase to an economic-impact-driven pricing phase, with the latter requiring more time to assess actual economic damage and progressing more slowly—"but this does not make us optimistic".

Risk Warning and DisclaimerThe market has risks, and investment should be cautious. This article does not constitute personal investment advice, nor does it take into account the specific investment objectives, financial circumstances, or needs of individual users. Users should consider whether any opinions, views, or conclusions in this article are suitable for their particular circumstances. Invest accordingly, at your own risk. ```