Outlook 2023, Global credit: active approach to be rewarded?
Outlook 2023, Global credit: active approach to be rewarded?
It’s no exaggeration to say that 2022 has been the worst year for credit in recent memory. However, with valuations on both government and corporate bond markets looking attractive again, there is much to be encouraged about as we move into 2023.
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Financial markets are starting to adjust to a new market environment. One in which central banks continue to become more hawkish and move away from the era of quantitative easing (QE), while inflation is expected to reach its peak.
However, concerns about global recession remain high, although it is still too early to say how deep or protracted the downturn will be.
Greater dispersion and attractive valuations
With emerging market central banks having already raised interest rates meaningfully, developed markets have followed suit in tightening financial conditions this year with a series of rate hikes. The higher financing costs have started to squeeze growth and we should see interest rate-driven volatility in bond markets subside in 2023.
The subsequent repricing of government and corporate bond markets has made valuations attractive on both a spread and an absolute yield basis. Corporate fundamentals are strong as we enter a slowdown and some deterioration is expected over the year. In fact, the current valuations are mostly reflecting this year’s poor sentiment, providing a great income profile for global credit with a lot of bad news already priced in.
Global Credit Yield ($ hedged)
Inflation, which has been the key concern of the market, may be close to reaching its peak. Things are looking up in the US, where inflation data is showing signs of stabilising and even declining. European inflation, exacerbated by the war in Ukraine, is also expected to peak, but lag the path of US inflation.
The greater dislocations and spread ranges within the market, as well as the greater distinction between sectors, will allow for not only better sector allocation but, more importantly, for the global credit market to move back to the fundamentals. This creates an opportunity for active global credit investors to generate strong returns in the new year.
Martha Metcalf, Head of US Credit Strategies, said: “Central banks have severely distorted certain markets and it will take time for those distortions to work through the system. This creates opportunities since dispersion will remain elevated for active managers who can capitalise by dynamically managing regional shifts, industry allocations and hedging strategies.”
€ IG corporate spread dispersion – provides good alpha opportunities
Saida Eggerstedt, Head of Sustainable Credit, said: “In a dispersed credit market, governance will stay in focus. Companies that engage with stakeholders for improving their longer-term sustainability are being preferred over companies where management and/or board has a conflict of interest, and financial reporting is not prudent. Disclosure by investee companies will need to improve with regulators as well as our customers who are asking deeper ESG questions.”
Corporate fundamentals have stayed strong, but some deterioration can be expected
Corporate fundamentals have stayed strong throughout the year, but there are possible earnings challenges up ahead as a slowing economy weighs on sales growth. This could cause challenges for cyclical sectors (sectors that follow the ebbs and flows of the economy) where earnings usually fall more in downturns.
Rick Rezek, Global Credit Portfolio Manager, said: “Companies are well-positioned to navigate a more challenging environment, though we do expect greater differentiation between sectors and issuers as 2023 progresses.”
The key challenge for companies this year will be slowing global growth and the possible deterioration of consumer strength as prolonged high inflation keeps eating away at the purchasing power of consumers.
Jan Hennig, Portfolio Manager for European and Sustainable Credit, said: “For European investment grade issuers, medium-term borrowing costs are now three times higher than the average coupon they are paying on outstanding debt. However, IG corporates have taken advantage of recent low rates to extend the maturity profile and hence the refinancing risks are manageable in 2023.
"Combined with business surveys reflecting a pessimistic outlook going into next year, we think companies will be more cautious in their use of leverage. Recently we have seen a number of issuers committing to a more conservative financial policy, less debt funded M&A and paying down debt. We expect this trend to continue next year.”
Slowdown on the horizon
The BAML MOVE index, which measures US interest rate volatility, more than doubled during the course of 2022, but has now fallen significantly. Yet, it still remains elevated. This reflects the fact that the Federal Reserve (Fed) is further along in its hiking cycle than other developed markets.
The aggressive nature of rate rises has led to significant spread volatility. This volatility will, however, decrease once the Fed pauses or slows the rate hikes.
In Europe, expectations for recession this winter are likely to come to pass, followed by a weak recovery. Although governments are implementing fiscal measures to help consumers and business, these do put into question country deficits and general debt sustainability over the medium to long term.
Currency hedging costs have now moved in favour of European credit, which is a material change from the recent QE years when US credit was favoured. This shift has made European credit very appealing for foreign investors.
Julien Houdain, Head of Credit Europe, says: “Global credit markets are now providing attractive all-in total return potential - price gain plus income. As to which market is now more attractive, the answer is nuanced - Europe is notably a lot cheaper, while any US recession is likely to be shallower.
“With higher interest rates and central banks ending QE, companies will need to focus on robust businesses and healthy balance sheets if they are to thrive when global growth faces headwinds. This means that there will likely be plentiful opportunities to differentiate between risk and value in credit.
“This is why we look to bottom-up stock selection to add value; focusing on building conviction trades at the company level and on themes, while looking to build natural geographical and sectoral diversification.”
Peak to trough drawdown for $ IG corporate index worst in over 45+ years – but subsequent returns post crisis have been healthy historically
The recovery of Asia investment grade credit
In Asia, the credit market faced several headwinds throughout the year, caused by hawkish central banks, geopolitical tensions, and China’s zero-Covid policy and housing market woes. However, it looks as if valuations have now reached levels that are starting to look attractive for long-term investors.
The JP Morgan Asian Credit (JACI) index now yields 7.6% and is at the highest pick-up compared to Asia Pacific Ex-Japan dividend yields since the financial crisis in 2008.
Peng Fong Ng, Head of Asia and Emerging Market Credit, said: “Asia investment grade (IG) credit has displayed resilience relative to developed market and emerging market IG in 2022, with net leverage relatively low at 2x and interest service coverage still healthy. The segment’s stable corporate fundamentals is supportive for valuations going forward and can help to provide a buffer heading into a growth slowdown environment. Over the longer term, Asia IG should also benefit once rates begin to stabilise when the Fed eventually pauses or pivots.”
The Asia high yield (HY) market, however, is likely to stay volatile with elevated idiosyncratic risks, particularly for China property.
“While we think China’s recent relaxation of Covid rules and coordinated set of property support measures can help reduce systemic risk, a full reopening is unlikely in the near term and a sustained property market recovery will depend a lot on policy execution and future supportive measures. Thus, until a solid pick-up in physical housing sales is observed, we prefer to limit China property exposures to only the strongest players, especially considering that offshore creditors appear to have been treated with less priority versus onshore obligations,” Peng Fong Ng said.
The green bond market is likely to continue to grow next year after green bonds dominated the issuance within ESG corporate bonds this year. In addition, there might also be further issuance of sustainability linked bonds (SLBs) in the high yield bond market in 2023.
Saida Eggerstedt said: “Interest for investing in social impact through public credit market is also likely to grow. This will mainly focus on human capital, but also circular economy and preserving nature will be big themes next year as all these have a longer-term effect on health, food and water systems, as well as inequality.
“Most industries depend on forests and nature, and we as credit investors must engage with companies to place greater emphasis on the circular economy as well as sourcing materials sustainably. We will look for issuers that provide solutions for responsible consumption and conservation, access to healthcare and education, as well as issuers combatting inequality.”
Managing risk through active global strategy
Despite the improved outlook for credit in 2023, some concerns still remain, especially in the form of a synchronised global recession.
Martha Metcalf said: “This risk is best managed through active management and a diversified portfolio with the flexibility to pivot across regions, industries, ratings and issuers. The year is likely to be rich with opportunity and nimble investors will be rewarded.”
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