A swift vaccine rollout and economic reopening is helping support corporate fundamentals but investors are wary of inflation and how investment grade (IG) markets will respond.
Fundamentals are improving but be wary of inflationary pressures
As the vaccine rollout continues to progress across developed markets, governments are beginning to ease restrictions and economies are gradually reopening. This step back towards normality is likely to bolster growth in the coming quarters. The International Monetary Fund estimates that the global economy will expand by 6% in 2021, the most since 1980 - a record high. As growth rebounds, earnings should recover further and likely outpace debt growth, leading to a natural decline in overall leverage and healthier corporate balance sheets.
While faster growth and improving fundamentals are well received by investors, the vaccine led reopening has also triggered inflationary concerns amongst market participants. Headline inflation in the US reached 5% (y/y) in May 2021, its highest reading since April 2008, while the UK’s May inflation print was the highest in nearly two years. While some of the recent uptick in inflation is likely to be transitory, there are concerns that higher inflation is here to stay.
At the headline level, the U.S. Investment Grade (IG) market looks well positioned to manage in a rising inflation environment. The relatively strong relationship between the operating margins of US IG companies and US Core CPI shown in chart 1 indicates that companies have the ability to pass on cost pressures to customers, helping protect profit margins during periods of rising inflation. However, not every sector is made equal. Commodity orientated industries such as metals & mining or energy have significant pricing and production flexibility, allowing them to navigate a higher inflation environment relatively easily. Meanwhile a rising inflation environment should increase the input costs and wages, placing margin pressure on industries such as autos or the retail sector. The takeaway for investors is that a degree of active management is required to identify those issuers and industries best positioned to withstand any future cost pressures.
Chart 1: Correlation between operating margins of US IG companies and US Core CPI.
Finding opportunities within IG markets
The improvement in corporate health and economic fundamentals has triggered a dramatic narrowing in spreads, particularly amongst cyclical sectors such as autos, chemicals, metals and mining. Spreads in these more cyclical sectors are tighter (between 30-60 basis points (bps)) compared to pre-COVID levels; suggesting that much of the future economic recovery is now fully priced in to current valuations. Some sectors such as lodging and airlines are still trading over 40 bps wider compared to pre-COVID levels. These sectors continue to face headwinds related to the pandemic as investors show signs of concern around their long-term recovery plan.
Where can investors find value in the IG corporate market at current tight valuations? While much of the cyclical recovery is now priced into valuations, we continue to find opportunities in ‘carry’ sectors such as, pharmaceuticals, communications and utilities that all have some room for further improvement. In addition, opportunities remain within the financial sector. Banks have demonstrated their resiliency through this recent downturn, supported by robust liquidity and significant capital buffers. However, bank capital continues to offer relatively attractive valuations, especially further down the capital structure.
Despite the significant spread tightening seen since March 2020, the strong fundamental backdrop and supportive technical environment continues to assist IG credit markets. Corporations look well positioned to navigate any bouts of inflation albeit with some divergence across sectors. While headline spreads have narrowed significantly since their wides in March 2020, we believe that there remains opportunities in ‘carry’ sectors of the IG market such as utilities and communications as well as in bank capital.