Summary
Our view is that the US economy is at its late stages of the economic cycle. US economic growth continues to slow, given the impact of the most rapid increase in short term interest rates in history. The impact of this increase can be seen in weakening credit fundamentals. Slower consumer spending, higher energy costs and higher labor costs are impacting margins. Furthermore, given higher yields, companies are experiencing a large increase in interest costs upon refinancing. These factors point to declining fundamentals and inhibits any spread tightening. However, the US Fed has signaled that we are near “peak rates”.
Higher rates have kept demand for investment grade (IG) credit up. As the economy slows there is a possibility for the Fed to begin easing, which is usually bullish for credit, a scenario that has likely been delayed to 2024 or later. This, and a healthy demand for corporate bonds provide a positive technical picture that keeps spreads from materially widening.
Therefore, for the 4th quarter of 2023, we feel spreads will remain range bound, and we expect most of the returns to come from carry (coupon income) rather than price appreciation (spread tightening). Given the steeply inverted yield curve, we favor the shorter end of the curve for its higher carry and lower volatility given a possible “higher for longer” interest rate scenario. Our favored sectors include Electric Utilities, Communications and Consumer Staples. We remain cautious on the Banking sector, not because of fundamentals (US Banks are very solid fundamentally in our view) but because of the supply of new issues from having to raise additional capital due to new regulations.
Growth continues to slow
The following charts show the 12 month growth in revenues for the universe of IG companies as well as their profit and EBITDA margins. 12 month growth in revenue has fallen to less than 5% from a high of about 15% in 2022, with narrowing margins (albeit from healthy levels). Fundamentals have stopped improving.
Figure 1: 12m growth in revenue / Profit margin, EBITDA margin
Source: Citigroup
EBITDA – earnings before interest, taxes, depreciation, and amortization
We see further risks to revenue and margins. Higher energy prices and a resumption of student loan payments will crimp consumer spending. Capex growth too has slowed significantly, confirming our late cycle view
But demand is still strong, higher yields cushion a slowdown
Year-to-date, the average monthly inflow for IG funds and ETFs has averaged $20 billion (according to data from EPFR). Investors are favoring the higher yield environment with investment grade bonds providing a yield of 5.85%, highest since 2009. This is a very attractive yield for investors despite a slowing economy.
If the economy were to materially slow, given higher treasury yields, there is room for yields to fall when the Fed begins easing. Lower treasury rates will likely cushion any negative impacts from spread widening due to weaker fundamentals.
Carry over Price
We think it makes sense for investors to take advantage of the inverted yield curve (where long-term interest rates are less than short-term interest rates) to earn extra carry from the front end of the yield curve with lower volatility. This benefits investors in a low spread volatility environment as we think spreads will remain rangebound and there is limited room for price movement. At the other end of the curve, there are strong technical factors supporting the long end. These bonds tend to be issued by very high quality companies, but year to date, less than 15% of new issues have a tenor longer than 20 years*. Asset-liability management buyers need long dated corporates to immunize their portfolios, so there is a strong demand supply imbalance, keeping spreads from widening significantly. We think that when the Fed starts to ease monetary policy, the front and the long ends of the curve will be beneficiaries.
* Source: Jefferies and Bloomberg
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