Economic backdrop
After a steady stream of interest-rate hikes, the world’s central banks seem to finally be making progress in reining-in inflation. European and UK inflation rates have declined sharply in recent months, however, worries about a looming recession remain. Meanwhile, in the US, the annual core rate of inflation in October dropped to its lowest point since August 2021. Overall, the US economy has held up quite well, especially when compared to those elsewhere in the world. While it has been able to avoid recession, there are hints that economic growth may finally be slowing in the wake of the Federal Reserve’s higher-for-longer interest-rate policy. US consumers pulled back on retail spending in October, raising concerns they may be running out of steam as they head into the holiday season. On the manufacturing front, recent surveys showed a dimmed outlook with a noticeable negative shift in the comments from participants. This sets up a more challenging dynamic for the economy going forward.
Still, despite the recent signs of cooling, the US economy has fared better than those in Europe and the UK, which appear to be on the precipice of recession. GDP for the 20 countries that comprise the eurozone declined by an annualized 0.4% in the third quarter after scratching out a meager 0.6% gain in the second quarter. Meanwhile, China’s property bust continues to serve as a drag on that country’s economy, despite government efforts to mitigate the fallout.
We currently hold that the US economy will experience a recessionary-type environment in 2024 but are cognizant to the prospect of a positive, albeit sub-trend growth scenario playing out. A main difference in these two scenarios is the speed of rate cuts on the other end—faster in the former and slower in the latter. We also see Europe and the UK heading into a shallow recession next year as the impact of central banks’ higher interest rates feeds into those economies.
Global corporate credit research overview
- Fundamentals generally stable, but softer economic environment to pressure growth and margins
- Increasing divergence between higher- and lower-quality issuers with companies with near-term maturities and limited access to the markets becoming more concerning
- Consumer sectors, especially services, are expected to be more resilient than companies in the basics and industrial space
- Continue to favor sectors and companies better positioned to weather a softer economy and higher rates
The anticipated slowdown in economic activity is taking hold, putting some pressure on margins and earnings growth. The impact on balance sheets and overall credit metrics will likely remain somewhat muted, resulting in continued stable fundamentals across most sectors. That being said, with higher rates and a weakening economy we expect a greater divergence between high-grade and levered issuers in 2024.
The rate hike cycle seems to be largely complete, which has reduced demand and begun to lower inflation, although it still remains at elevated levels. Lower inflation is more notable in consumer goods sectors, as services-focused companies continue to see strong demand as the post-pandemic shift toward travel and other experiences continues. Wage inflation remains resilient however, buoyed by low unemployment that has only recently showed signs of easing. This has also supported consumer spending, with concerns concentrated in lower-income cohorts impacted by rising borrowing costs and tightening lending standards. At the same time, higher-income consumers have also become more cost conscious with increased purchasing activity at higher-value/lower-cost retailers.
Supply chains have largely normalized, allowing inventory levels to come down, free up capital and lower just-in-time logistics costs. However, there are pockets of issues in certain consumer and basics sectors that could lead to some price discounting to preserve market share. The slow recovery in China has created headwinds for many industrial companies, including those exposed to commodity prices in the chemical, metals/mining and energy sectors. Interest-rate sensitive sectors such as housing and autos are relying on increased incentives to support demand. Financials appear to have stabilized following difficulties in US regional banks and Credit Suisse’s failure early in the year. Consumer credit profiles and commercial real estate loans remain in focus, but most larger firms appear to have manageable exposures.
Capital adequacy levels across financial companies and leverage ratios across corporates in most industries are healthy, though interest coverage ratios and cash balances are expected to continue declining from recent highs, notably in the levered credit markets.
We expect debt-financed mergers and acquisitions and leveraged buyout activity will remain subdued due to higher financing costs, increased regulatory scrutiny and an uncertain economic environment. As a result, those with strong free cash flow generation and well-positioned balance sheets may shift some capital allocation toward shareholder-friendly activities.
After several rating upgrades in the energy sector, we expect more balance going forward between rising stars and fallen angels, though within high yield we expect downgrades to outpace upgrades. In a higher-for-longer interest-rate environment, companies with near-term maturities are becoming more concerning, particularly for those with the lowest ratings that may have limited market access. Overall, we remain cautious, favoring companies and sectors better positioned to weather an uncertain economic landscape.
Fixed income outlook
- Higher yields present opportunity despite ongoing volatility, economic uncertainty
- Sector and security selection will be key given the likely economic slowdown
- Avoid taking on risk without getting paid for it given weakening growth
Fixed income assets are set to begin 2024 at broadly attractive levels, with Treasury yields near their highest since the financial crisis, albeit off recent peaks. The repricing higher in yields has increased breakevens (or yield per unit of duration) to their most compelling levels in years, which can offer protection against ongoing volatility or further increases in yields.
The recession, which many market participants had anticipated in 2023, never materialized. Instead, a surprisingly resilient economic backdrop amid restrictive monetary policy sent long-dated yields higher, leading to a challenging return environment for fixed income investors. Expectations continue to suggest an economic slowdown next year and the evolution of economic activity will drive market conditions in 2024.
While our base case implies a recessionary-type environment in 2024, a period of positive, but below-trend growth, remains a possibility. As the economy slows, excess returns for lower-quality credit products could face challenges, but an easier stance of monetary policy holds the potential to support total returns. Sector and security selection will be of heightened importance in an economic slowdown given the likelihood of concentrated pockets of weakness in the economy following a prolonged period of elevated funding costs. It is wise to be selective when considering spread-based fixed income opportunities and to avoid credits where investors are not getting paid for the risks given this slowing to no/negative growth environment.
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