Where do we come from
2023 was another turbulent year for capital markets. In March, the stability of the global financial system was once again challenged and volatility spiked, as Silicon Valley Bank in the US collapsed, and Credit Suisse was taken over by its longtime rival UBS.
Moreover, the rates market saw wild swings, as the US Federal Reserve, the European Central Bank and the Bank of England continued raising interest rates to bring inflation, which decreased from very elevated levels, back under control. At the same time economic activity was weak and economist speculated about a hard landing for parts of the global economy. While the US economy held up relatively well, the European economy and especially the manufacturing sector suffered from the tight financial conditions.
Geopolitical tensions remained high.
The credit markets had a nervous start into Q4. Stagflation fears led to wider credit spreads and US treasury yields climbed. However, November and December were positive months for bond markets, which rallied strongly on growing confidence that the cycle of interest rate hikes from the major central banks has now peaked.
The catalyst for this rally came with further evidence of easing inflationary pressures. The US Federal Reserve (Fed) kept rates on hold as anticipated, with a relatively dovish tone to the accompanying statement. Credit markets registered excess returns with positive sentiment propelling risk assets to outperform government bonds at the end of the year.
In this market environment, both Investment Grade and High Yield credit in euro recorded strong positive total returns.
2024 outlook
There are several good reasons to be positive about European investment grade credit in 2024.
1) Macroeconomic environment and central bank policy
With weak economic activity and clear signs of inflation declining in the Eurozone, it is getting likely that the European Central Bank has reached the peak of its rate hiking cycle. Moreover, the market is expecting rate cuts in the next year. This creates a positive backdrop for credit and the potential for gain from capital appreciation.
Inflation has fallen throughout 2023 and is expected to decline further to the 2% level targeted by the European Central Bank. This is likely to be driven by a decline in service inflation. The disinflationary impact from goods has already played out. Declining corporate profit margins are expected to create a dent in the labour market. Overall, we expect the labour market to weaken with cooling hiring intentions. However, we don’t expect a collapse in the labour market and a strong rise in unemployment. At the same time, we expect that the European economy is recovering from very low levels, as there is a stabilization in leading indicators. However, growth will remain at subdued levels. In that environment the manufacturing sector could see a recovery on the less restrictive monetary policy.
2) Bondholder friendly action encouraged
Higher interest rates have increased the cost of financing compared to the last years, shifting economic value from shareholder to bondholders. Hence, there is a strong incentive for corporations to reduce debt, cut costs and reduce Capex, as a large portion of their cash flow is going to bondholders. This will increase market dispersion, which provides a profitable hunting ground for bottom-up focused active investors like us. At the same time, there is low M&A risk.
3) Valuations
Despite strong returns in 2023 the party is not over yet; in fact, it has barely started. Current valuations are still attractive, as yields and spreads have not moved materially tighter from very elevated levels. The spread of the EUR IG market is sitting at the 76 % percentile compared to the last 10 years, which illustrates a premium vs. history. Moreover, the EUR IG market has been lagged other global IG credit markets this year and also looks compelling on a relative basis. Overall, the yields in EUR IG still offer the potential for attractive future returns, attractive income, and importantly a buffer against future volatility.
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