As more economists and strategists abandon their bear case views we argue it remains wise to stay cautious. History tells us that tightening cycles by central banks almost always lead to a recession, except in the mid-90s…
- Soft landing has become the consensus as inflation comes down
- Fed pivot has led to a rally in duration
- Market is priced for a best case scenario
The market is now pricing in a best-case scenario. Spreads have moved significantly, and parts of the US credit markets are in or shifting towards the bottom decile in valuations. We normally see this at the end of long bull markets and not in an environment like this.
Market technicals have improved in the last quarter on more stable rates markets. However, sentiment remains tenuous as we have witnessed throughout this year. Markets are priced on very high expectations and that means there is plenty of room for disappointment. It will take a more serious slowdown or recession to move markets more materially. We are comfortable holding a more neutral overall positioning while taking bottom-up risk in those parts of the market where we think risk-return is appealing. We are slightly long beta in investment grade and firmly hold our conservative positioning in high yield.
Fundamentals
When we look at corporate fundamentals, we are seeing margin compression in certain sectors. As inflation is coming down, pricing power seems to be on the decline as well. As wages lag, we think margin pressure could intensify going forward. Last year, sectors such as technology and heavy industrials struggled with declining margins. So far, few companies have been willing to let go of employees. Scarred by the difficulty to find staff and bolstered by the healthy buffers accumulated during Covid, companies have been willing to let margins slide over shedding labor costs. For some sectors, the luxury to retain staff may be gone.
"The banking sector globally remains relatively cheap
As more companies in the bond market need to refinance in 2024, these effects will soon become more visible. For high-leveraged companies, higher rates will have a material impact on a company’s financials. For investment grade companies the effects will, in most cases, be small. However, here we are seeing companies in need of capital allocation adjustments as well. For example, infrastructure companies like telecom towers and renewable energy need to adjust their balance sheets for higher rates. There are clearly winners and losers in this environment.
Valuations
The banking sector globally remains relatively cheap. In particular, senior bank bonds have generally lagged the market and can still be considered on the cheap side. AT1 bonds have performed quite well and are now below median levels, albeit still higher than pre-March. CCC-rated bonds have underperformed in the last few months and have decompressed versus single-B and BB-rated bonds. This does not mean it is time to add to this part of the market. Many CCC-rated companies are trading cheap for a reason. A number of those companies are witnessing severe margin pressure, or have too much leverage, and as result are finding it difficult to refinance at these higher interest rates. This part of the market is about idiosyncratic risk and cannot be approached from a top-down point of view.
"We have already seen a shift with more money flowing into credit
With many companies experiencing margin pressure or debt burdens too high for the current rate environment, we expect to see companies migrate in rating, or in the case of high yield, even default. We believe current markets are about issuer selection, balancing fundamentals and valuations.
Technicals
We have already seen a shift with more money flowing into credit, especially investment grade credit. With overall yields in investment grade credit still at attractive levels and with good return prospects, the asset class can compete with many other more risky classes. From a demand point of view, technicals look very good. On the negative side we will continue to see quant tightening from central banks. The Fed, ECB and BoE have all indicated they will continue to reduce their balance sheets. The ECB, in particular, holds a considerable position in corporate bonds that ultimately needs to be unwound over the medium term.
With the recent rally in credit markets and rates, we believe demand for credit will be met with new issuance. In the high yield market there is a maturity wall that needs to be dealt with. With yields now almost 2% lower than two months ago, we believe many issuers could start to address upcoming maturities. Although, several companies will still struggle to refinance due to high leverage. In investment grade, where companies have less financing needs due to long average maturity profiles, companies could come to the market to issue debt. Investment grade companies have been very reluctant to issue longer-dated paper in the last 12 months as a result of the high-rate environment.
"Technicals have improved considerably
In emerging markets the picture is rather different. We are already witnessing that companies, where possible, are choosing to refinance their offshore debt in the local market. Especially in Asia, where local interest rates are much more attractive than their USD equivalent. As a result, the hard currency EM market has been gradually shrinking and we expect this to continue into next year.
Conclusion
We have reached the end of one of the sharpest hiking cycles in modern history. Economies in Europe and the US have so far moved through it without being derailed. Markets have declared victory and fully embraced a soft landing. However, we remain cautious, as it is likely we have not fully seen the impact of the tightening cycle. Central banks are gradually pivoting, but rate cuts are still a few months away it seems.
High expectations are priced in. The market is partying like it’s the 1990s. This also means there is room for disappointment, and in such case spreads could move wider. However, we will need a more severe slowdown or recession to move markets more materially. We think the odds of this are still considerable, given the slow transmission of the tightening cycle.
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