In a recently published Market Commentary, Western Asset Management Chief Investment Officer Ken Leech declared that "the savage pummeling taken by credit markets is so out of proportion that there appear to be two parallel realties."

"The first is that the U.S. economy is in reasonable shape, exhibiting modest growth," Mr. Leech wrote.

"Unemployment continues to fall, the consumer is fine and the U.S. Federal Reserve (Fed) is considering how to continue on its path to normalizing interest rates."

"The credit markets are tightening in contrast. Credit markets are not only pricing in a recession, but have gone even further, pricing in a premium for systemic stress."

According to Mr. Leech, investors face divergent paths: according to the economic data, the situation seems reasonably serene; yet the credit market's black cloud suggests exceptional peril.

However, Mr. Leech advised: "We believe such extreme pessimism is unwarranted." 
But this will have a delaying effect on interest rate hikes by the Fed, Mr. Leech predicted.

"We believe the Fed is now on hold until the following three conditions are met: credit market conditions ease meaningfully, inflation expectations increase and economic growth conditions improve to where they are in line with the Fed's forecast," he wrote. "Achieving any one of these goals will prove challenging. Achieving all three will take quite some time."

The full Western Asset February 2016 Market Commentary can be accessed via the Western Asset web site. 

Mr. Leech's reasoning is founded on four factors, which may create opportunities for investors:

• Credit spreads have moved so violently in recent months that current pricing embeds not only a recession, but the strong possibility of systemic stress.

• China is casting a very large shadow over global growth and commodity price outlooks. Pessimism is extraordinary, but the downturn in Chinese growth is manageable.

• Odds of a global recession are very low. With the U.S., Europe and Japan growing modestly, global recovery will continue even if key emerging markets are challenged. If the base case is even close to right, opportunities in spread sectors will be substantial.

• If policymakers recognize inflation's absence to become more accommodative or less restrictive, returns could be as breathtaking on the way up as they were on the way down.

The economy cannot withstand the current tighter credit conditions, in Mr. Leech's view.  

"Even if current data appear resilient, the Fed cannot afford to let the tightening of credit conditions linger," he wrote. "The Fed is facing this challenge, even as the pace of U.S. growth seems to have slipped modestly from its 2.5 percent forecast. More important still, inflation expectations, which the Fed has consistently cited as being well anchored, are now falling."

"Tightening into markets suffering broad-based credit stress is likely to stifle growth. Tightening into markets with clear bank credit stress is dangerous. The lesson of the 1930s, the 2007-2008 crisis and the European crisis of 2011 seems pretty clear: banking stress is a sign of potential systemic risk. Tightening needs to be off the table."

Mr. Leech is less pessimistic than many forecasters about global growth, particularly in Europe.

"We believe global growth will continue at a roughly 3 percent rate, sluggish but not horrible," he wrote. "Europe is on track for just under 2 percent growth. This is not overly heroic given the many recent years of subpar growth. The banking challenges in Europe are significant."

Nonetheless, Mr. Leech concludes that, "we are in for a very difficult slog."

"There are many issues upon which to be anxious or negative, but growth and healing conditions develop more slowly. We believe the Fed is migrating to a pause in its normalization process, but it will take time before it announces an official reassessment of its economic outlook."

He also sounded a call to action for international monetary policymakers.

"Ever since the crisis, policymakers have been engaged in a long, grudging battle to help reflate the global economy. Market gloom is premised on the realization of more dire outcomes. Policymakers would do well to short-circuit such fears."