16 Aug 2023
AegonAM_2023_Mid-Year_Outlook_Global_Fixed_Income.pdf
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Macroeconomic backdrop
On a global basis, divergences between major economies and monetary policy started to play out over the second quarter. While the US economy is still showing some signs of strength, European and UK economies appear to be entering an era of stagflation; economic data is starting to surprise to the downside and inflation is still well above 2%, forcing the European Central Bank (ECB) and Bank of England to stay hawkish. China’s growth rebound has disappointed, but low inflation leaves room for stimulus to boost domestic demand. Japan, meanwhile, is gaining momentum from a rebound in consumer spending and business sentiment, driven in part by the reopening of its borders to international visitors.
We maintain our base case that the US is still heading for a mild recession which we expect to start in the fourth quarter of this year. Contractionary signals remain; the 2-year-10-year yield curve is the most inverted it has been during this cycle; the ISM manufacturing PMI is at its lowest point since Covid-19 lockdowns and liquidity has drained from the system post-debt ceiling standoff as banks buy up Treasury bills. The market seems to be forgetting that monetary tightening hasn’t gone away. The Fed is pushing on with its quantitative tightening, and with two more rate hikes priced in this year, corporates and consumers will only face more pressure in the months to come.
While there are signs of cooling, inflation remains high and central banks are yet to trigger a meaningful slowdown to cool prices. This has put upward pressure on sovereign bond yields, as central banks have been given greater scope to continue their hiking cycles. Credit had a reasonable start to the year and continues to offer an attractive source of carry.
Shifting dynamics in global economies presents a challenge for investors so staying active and flexible will be key to navigate what may prove to be challenging times ahead.
Global corporate credit research overview
We continue to anticipate a more difficult economic environment that will put pressure on margins and earnings growth. However, it will likely have a more muted impact on balance sheets and overall credit metrics, resulting in continued stable fundamentals across most sectors.
Continued rate hikes are reducing demand and beginning to lower inflation. This is more notable in consumer goods sectors, as services-focused companies continue to see strong demand as the post-pandemic shift toward travel and other experiences continues. Inventories are generally in good shape across many sectors, however, there are pockets of issues emerging in certain consumer and basics sectors which could lead to some price discounting to preserve market share. Nevertheless, in many cases, demand is still holding up, allowing margins to normalize above long-term averages. A slower-than-anticipated recovery in China has put downward pressure on commodity prices but has also created headwinds for companies in the chemical, metals/mining, and energy sectors. Financials appear to have stabilized following difficulties in US regional banks and Credit Suisse’s failure early in the year. Commercial real estate loans remain in focus, but most larger firms appear to have manageable exposures.
Corporate leverage ratios and financial sector capital adequacy are healthy across most sectors. Cash balances also remain high, providing a cushion to weakening fundamentals. We expect debt-financed mergers and acquisitions (M&A) and leveraged buyout (LBO) activity will remain subdued due to higher financing costs, increased regulatory scrutiny, and an uncertain economic environment. As a result, those with strong free cash flow generation and well-positioned balance sheets may shift some capital allocation towards shareholder-friendly activities.
After several rating upgrades in the energy sector, we expect more balance going forward between rising stars and fallen angels. But rising funding costs and market access for some issuers are becoming more of a concern. Overall, we remain cautious, favoring companies and sectors better positioned to weather an increasingly uncertain economic landscape.
Fixed income outlook
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Please download the PDF below to read our outlook in its entirety, including individual asset class outlooks.
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