The shift in the macro backdrop in 2023 provided a tailwind for fixed income across the board. Investment grade (IG) credit was very much a part of the rally, with credit spreads moving meaningfully tighter last year. As we start 2024, we explain why we are optimistic about IG credit.
Change in direction for inflation and rates
One of the biggest changes since mid-2023 is the outlook for inflation and interest rates. In the US and Europe, inflation has come down towards the central banks’ 2% targets, prompting surprisingly dovish pivots from the Federal Reserve (Fed) and the European Central Bank (ECB).
Historically, as central banks begin to cut rates, credit spreads have exhibited greater dispersion in month-over-month changes, compared to hiking cycles or periods of rate stability. This volatility should offer active managers opportunities for excess returns at a time when corporate fundamentals appear robust.
Exhibit 1: Monthly US IG spread changes during different Fed actions
Monthly Spread Change Split by Fed Action
Source: Bloomberg Barclays. As of 11/30/2023.
Corporate fundamentals are holding up
Global IG company fundamentals remain solid against the shifting macro backdrop. The combination of moderate growth, slowing inflation and central bank easing bias 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 growth ticked up vs. the prior quarter. Gross debt growth remains flat while both gross and net leverage have stabilised at pre-Covid levels.
Even in the most conservative scenario of a recession, we expect earnings for many sectors in the US IG space converge to around flat growth. However, in our base-case scenario of a soft-landing, earnings are expected to be positive in all but one sector (autos) across the time frame.
Exhibit 2: Next 12 months earnings estimates by sector under a recession scenario
"Recession" Case EBITDA T12m estimates by sector
Source: J.P. Morgan Asset Management, median IG industrial company. Median data as of 31/09/2023, forecasts through 31/09/2024. *Estimates (Q423 –Q324). EBITDA = earnings before interest, taxes, depreciation and amortisation. Past performance is not a reliable indicator of current and future results.
In Europe, we expect revenues to 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 an 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 from 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
Supply and demand dynamics for IG bonds should be supportive in 2024. Retail demand in the US tends to correlate with positive returns and this should persist throughout the year. On the supply side, we anticipate around $275 billion of net US issuance in 2024 – shaping up for perhaps the lowest net supply growth year on year since 2019.
How tight is tight?
While we believe fundamentals and technicals for the asset class remain robust, we recognise there is less conviction from a valuation perspective.
Putting current spread levels in context, we analysed how frequently the US IG index has traded at similarly tight levels. 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 showed that spreads wider than 110bps offered a consistently higher probability of achieving a positive excess return but when there was a negative excess return, the drawdown was more severe.
