In brief

  • Global investment grade (IG) company fundamentals are holding up as the macroeconomic environment adjusts to lower inflation and the potential for interest rate cuts.
  • Our base case macroeconomic scenario is sub-trend growth, an improvement from an equal-weighted probability with recession at the end of the third quarter, which should continue to support IG fundamentals.
  • IG technicals in the US and Europe remain supportive, though spreads have tightened. European IG spreads are relatively attractive vs. US IG spreads.
  • The long end of the US IG spread curve continues to look attractive and we also find value in European IG senior and non-financial subordinated debt (hybrids) and additional tier 1 (AT1) securities.

Change in direction for inflation and rates

One of the biggest changes since our 2023 mid-year piece is the outlook for inflation and interest rates. In the US and Europe, inflation has come down towards the central banks’ targets of 2%, prompting surprisingly dovish pivots from the Federal Reserve (Fed) and the European Central Bank (ECB).

Against this backdrop, we have increased our probability estimate for above-zero global growth to 65%, while the probability of recession (including a crisis scenario) dropped to 35%.

Historically, as central banks begin to cut rates, credit spreads have exhibited greater dispersion in month-over-month changes (Exhibit 1), compared to hiking cycles or periods of rate stability. This volatility should offer active managers opportunities for excess returns at a time when we continue to favour corporate fundamentals.

Corporate fundamentals are holding up

Global investment grade (IG) company fundamentals remain solid against the shifting macro backdrop. The combination of moderate growth, slowing inflation and central bank bias toward easing creates a very different macro backdrop from recent years and, in our view, a powerful tailwind to bond markets.

In the US, median industrial revenue growth continued to slow in 3Q 2023 yet earnings (defined as earnings before interest, taxes, depreciation and amortisation) growth ticked up vs. the prior quarter. Gross debt growth remains flat while both gross and net leverage have stabilised at pre-Covid levels.

Our analysts’ bottom-up estimates for US IG industrial earnings growth over the next 12 months show that even using more conservative ‘recession’ assumptions, earnings for many sectors are starting to converge around flat earnings growth (Exhibit 2). Should a recessionary outcome occur, several sectors are forecast for negative growth however in a more consensus soft-landing scenario, only one sector (autos) is expected to have negative growth across this time frame.

In Europe, we estimate that revenues will stabilise through the middle of 2024. Balance sheets generally remain robust with leverage at the low end of historical ranges, and management teams have generally been disciplined in capital allocation, with a continued emphasis on strong liquidity and ratings stability.

The US banking sector has stabilised after a challenging start to 2023. Earnings power is offsetting elevated losses due to office commercial real estate exposure and regional banks have been attracting deposits.Deposit trends in Europe show greater stickiness and improved pre-provision operating profit means comfortable headroom to absorb the higher cost of risk.

Technical support remains strong

Technicals for IG bonds should be supportive in 2024, driven by both strong demand and modest supply. Retail demand in the U.S. tends to correlate with positive returns and should persist into 2024, and foreign demand expectations continue to be supportive. Recent trends in European IG demand, led by insurance flows and fixed maturity/target date funds, also look set to continue.

Our research analyst team conduct bottom-up estimates of US IG supply and forecast approximately $275 billion of net issuance in 2024. This is lower than 2023 and might be the lowest net supply growth year on year since 2019. We recognise there is likely to be opportunistic supply from issuers seeking to take advantage of an environment of lower yields and spreads, however the overall supply picture is supportive from a technical perspective.

How tight is tight?

Spreads have moved meaningfully tighter last year, with global IG corporate spreads closing at 115 basis points (bps), 32bps tighter through 2023. While we believe fundamentals and technicals for the asset class remain robust, we recognise there is less conviction from a valuation perspective for IG credit than several months ago.

Putting current spread levels in context, we analysed how frequently the US IG index has traded at similarly tight levels (Exhibit 3) and found that since 2001, the index has spent a third of trading days inside 110bps and almost a quarter of time inside 100bps (US spread levels were 99bps as at 29 Dec 2023). Additional analysis shows that while spreads wider than 110bps offer a consistently higher probability of achieving a positive excess return, when there is a negative excess return, the drawdown is more severe.

Pockets of value in IG

Despite this overall tighter spread environment, we continue to find pockets of value across the IG universe. All-in yields in the long end of the US IG corporate curve are attractive vs. historical yield levels and should continue to entice yield buyers (Exhibit 4). The increase in pension funded status for the average US defined benefit plan, as well as UK pension schemes, has led to de-risking into high quality long IG corporates. As the US Treasury curve steepens to more normal levels, the corporate spread curve should also flatten.

European IG credit spreads still trade wide to US IG spreads (138bps vs 99bps at end-2023) and we also find European IG senior and non-financial subordinated debt (hybrids) attractive (Exhibit 5). Issuer fundamentals are solid, with positive momentum from ratings. For hybrids, outright spreads and senior subordinated multiples are cheap compared to historical averages and offer upside. They are also attractive vs. European BB industrial bonds, though we expect supply to increase in 2024.

Lastly, we find additional tier one capital (AT1) debt attractive, particularly from European banks. Spreads are still wide to recent tights and new deals have been performing well.

What does this mean for fixed income investors?

We move into 2024 with a continued constructive view on fundamentals and technicals for IG corporates, balanced against a backdrop of overall tight spread levels following the significant moves in the final months of 2023.

Spreads are currently pricing in a relatively low probability of recession but we expect increased volatility as markets navigate the directional change in monetary policy. Active managers can look for opportunities to add to positions in these periods of volatility and we highlight current value in areas such as the long end of the US IG corporate curve and European investment grade hybrids.

With central banks likely to begin easing and yields moving lower, all-in yields are attractive and it remains an opportune time for investors to buy credit.

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