Fundamentals

Falling gas prices and a relatively mild winter have helped European inflation to come down from its peak of 10.9% year on year in October 2022. Purchasing managers’ indices show signs of improving sentiment and forward-looking indicators suggest that the downturn is likely to be more benign and shallow than anticipated last year. It’s not only recent economic data that has surprised positively, but also the position of European corporates. What we typically see when entering recessionary territory is a build-up of debt growth on corporate balance sheets. This time, things are different, with companies successfully piling up savings and strengthening their balance sheets in the aftermath of the Covid-19 pandemic. Net leverage of European corporates (excluding REITs, financials and utilities) stood at 1.7x at the end of September, which is below pre-pandemic levels of 2.1x at the end of 2019 (source: J.P. Morgan Asset Management). While revenue and earnings growth have shown signs of moderation, as anticipated by investors, both revenue and earnings growth are still well above long-term averages. These low debt levels give corporates breathing room to manage their debt structures accordingly, even if earnings were to fall from here. Overall, corporate balance sheets enter 2023 with better liquidity and lower leverage.

Quantitative valuations

Yields are looking attractive in absolute terms, currently sitting at around 3.75% in the investment grade space, with a spread of 150-160 basis points (bps). However, yield levels – as well as the improved European economic outlook and strong fundamentals – are complicated by two factors. First, there remains uncertainty around how the economic outlook develops from here. The ongoing Russia-Ukraine conflict, the outlook for winter temperatures and energy prices, as well as China’s reopening and the implication for supply chains are just some of the issues that investors need to consider. Second, markets have started to buy into the narrative of an improved outlook, with spreads having tightened meaningfully in the first three weeks of 2023. Currently, a recession probability of about 40% is priced in based on historical spread ranges throughout cycles. Interestingly, a few months can make a meaningful difference when comparing the US credit market to Europe. European investment grade (IG) spreads have historically traded inside their US equivalent, but given the more pronounced recessionary fears, particularly in Europe, this relationship has reversed. We see the potential for a convergence of spreads in both markets, linked to a dissipation of economic headwinds in Europe and recent data softening in the US.

Current spread levels imply a 40% recession probability

Source: J.P. Morgan, Bloomberg, Federal Reserve Bank of St. Louis, Organization for Economic Co-operation and Development (OECD). Recession indicator is based on St. Louis Fed / OECD methodology. Data as of 23 January 2023.

Technicals

In a similar fashion to 2022, investment grade credit markets have started the year with a very strong issuance calendar. So far, January 2023 has seen EUR 61.7 billion of euro IG issuance, the highest ever monthly issuance in any January on record (data as of 20 January 2023 for euro IG index eligible bonds, source: Barclays POINT). This is only 1% above the issuance in January 2022; however, it is 41% higher than in 2021. While supply has been elevated, consistent inflows into the asset class have helped absorb this deluge of supply surprisingly well, reflected in narrowing spread levels. While the overall narrative has turned more positive, dispersion between issuers is likely to widen given different exposures to factors of uncertainty (such as energy prices and China’s reopening), providing a more fertile ground for alpha to be added.