In brief
- Global investment grade (IG) company fundamentals remain healthy, with earnings growth projected to continue in the mid-single digits and revenue, while losing some momentum, is still ticking up.
- Record supply has been absorbed well by robust demand. We expect to see supply heavier than usual because of ongoing pull-forward issuance in 2025, but do not anticipate a let-up in demand.
- Credit
spreads are narrow, but can grind tighter, especially if cash moves off the
sidelines.
- We
believe the intermediate point of the curve captures the best carry and roll
profile. We are leaning into the US healthcare and technology sectors. We like both
US and European banks, with a focus on European capital structures and select
Additional Tier 1 (AT1) securities. We continue to like hybrids issued by
midstream energy and utility companies.
A moderation in growth momentum
Economic growth has cooled, consistent with a slower economy. We see the steeper cuts now priced in from the US Federal Reserve (the Fed) as a quicker path to policy normalization, rather than a cause for concern. Against the current macro backdrop, our Global Fixed Income, Currency & Commodities team holds a 60% probability of sub-trend growth, with a balance in tail risks to above-trend growth (20%) versus recession (15%) and crisis (5%). This type of environment is typically constructive for IG credit risk.
Central banks are now cutting to normalise policy, we believe this is most closely aligned to the soft landing period in the mid-1990s, during which IG credit performed well as spread volatility was muted and spreads ground tighter.
IG fundamentals remain healthy
Our analysts have adjusted 12-month forward EBITDA (earnings before interest, tax, depreciation and amortization) estimates marginally lower compared to last quarter. We project US EBITDA to continue along the path of mid-single digit growth. Top-line revenue, while still growing at a low single digit pace, is losing some momentum. For revenue growth to accelerate, we would look for a broader pickup in growth associated with a more accommodative Fed.
Europe appears to be following a similar path to recovery as the US, with a year lag. We expect the majority of sectors in Europe to show positive EBITDA growth into early 2025.
US companies have done a great job of maintaining margins by maximizing efficiencies where possible. We have not seen, nor are we expecting to see large layoffs in the near term.
The one-year forward EBITDA estimates for the US IG industrial index median are projected to grow by 5%, with most sectors within a +/- 2% range. Healthcare is a notable outlier on the upside, driven by the ramp-up of GLP-1 treatments and advancements in gene therapy and vaccines. Medical device companies are seeing improved pricing power, supported by full employment and the resolution of pandemic-related backlogs. Conversely, the energy sector stands out as underperforming due to lower current and forward commodity price expectations versus the last several quarters.
While our overall expectations for the US autos sector remain stable, European autos present key risks. Over the past two-to-three years, European autos have benefited from selling internal combustion engine (ICE) vehicles in China. However, this advantage could diminish if China imposes retaliatory tariffs on Europe. European autos are becoming less competitive compared to Chinese brands due to substantial capital expenditures on electric vehicles (EVs) driven by stringent regulatory requirements, which have not met expected demand. These companies also face additional labor challenges from a larger workforce versus the US.
We expect the majority of European sectors to show positive EBITDA growth into 2025, however those companies with more exposure to China look to be on a lower trajectory. Much will depend on how effective Chinese stimulus measures are.
In financials, the major six banks appear prepared for the regulatory capital requirement changes. In the near term, we expect muted net supply in US banks’ seniors and negative net supply in preferreds, providing a positive supply technical through the remainder of the year. Our positive assessment of European banks remains unchanged, particularly regarding asset quality and capital strength. Net interest income (NII) has remained resilient and was revised higher by several European banks for fiscal year 2023 (FY23). We expect loan growth to be in the low single digits for 2025 across the US and Europe. In both regions, we are comfortable with moving down the capital structure into names that have strong fundamentals to pick up additional spread. An area of the market that we particularly like is AT1s.
Robust demand is absorbing front-loaded supply
Year-to-date supply in both the US and Europe has surpassed expectations due to a pull-forward of issuance from future quarters and unanticipated merger and acquisition-related activity. History shows that supply is typically higher than usual when the Fed is cutting rates. Using Q125 maturities (~$270bn) as a guide, FY24 issuance could be anywhere from ~1.3trn to ~1.5trn. The elevated supply numbers have been facilitated and absorbed by strong demand, which has been firing on all cylinders in the US - retail flows have continued to run at 4+ bn per week (according to EPFR data), dealer balance sheets are extremely light, there is strong secondary buying activity, and offshore demand is getting stronger with Japan starting to participate more as JPY-hedged spreads have reached their highest levels since 2022. We are also seeing strong demand in Europe, with European new issues averaging three- to four- times oversubscribed. More broadly, demand has tracked gains in total return and these positive rolling total returns should continue to attract retail flows. We do not anticipate a let up in this demand, especially if cash moves off the sidelines as investors look to lock in the elevated yields on offer in IG credit.
Parallels with the 90s
Global IG spreads ended the third quarter of 2024 at 100bps, tightening from 115bps year to date (YTD). US IG spreads have tightened 10bps YTD and ended the quarter at 89bps. European and sterling IG corporates closed at 117bps and 121bps respectively, outperforming the US market by tightening 21bps and 18bps this year.
Current IG corporate spreads are narrow compared to recent history, but we believe there is a path for spreads to move tighter from here. Looking back to the 1990s, the US IG Corporate index has spent 37% of the time trading inside 100bps. During the soft landing period of 1995 (which we view as somewhat comparable to the current environment), spreads traded around 50bps-70bps. The composition of the index has changed since 1992, with a decline in the average credit quality and a lengthening in duration of approximately two years. Given this, if we take today’s index composition at 1990s valuations, we would be at spreads of ~57bps. Highlighting the potential path for tighter spreads. Fed cutting cycles (excluding the global financial crisis) also show a bias to small positive excess return, implying modest spread tightening evenly distributed across the curve from here.
What does this mean for fixed income investors?
Global IG corporate fundamentals remain robust and our base case is for sub-trend growth and a soft landing, which should continue to support fundamentals. We expect demand to stay strong and provide a positive technical for the market. This backdrop provides a runway for spreads to grind tighter.
From a portfolio construction perspective, we continue to like areas of the market where we can pick up additional spread, particularly European capital structures and select AT1 exposures. We have also been finding potential in hybrid securities of midstream energy and utility issuers, which offer BB-like spreads for investment grade companies exposed to the structural demand for power in the US. We are focusing on the US healthcare and technology sectors, and see relative value in US autos over European autos. From a curve perspective, we favour the intermediate (seven- to ten-year) part of the curve to best capture carry and roll. IG spreads are optically tight, but this is partly due to the richness at the long- and front-end of spread curves. From a historical perspective, the seven- to ten-year part of the curve is cheaper than the index average, and combining both spread and expected credit return from the bonds ageing (rolldown), prospective returns are highest in this bucket.
Should our projections of a soft landing materialize, the Fed would have the latitude to continue with the normalization of interest rates, which would be decidedly favorable for corporate fundamentals.
However, it is prudent to acknowledge potential caveats. We remain cognizant of the elevated geopolitical tensions and the forthcoming US elections. While these factors introduce elements of uncertainty, they are typically transient in nature. Ultimately, the trajectory of the economy will be the decisive factor in shaping outcomes.