22 Jul 2024
AUTHOR | Aegon AM Fixed Income Team
Macroeconomic backdrop
So far, much of 2024 has been a waiting game with the market focused on US inflation and when it might spur the Federal Reserve (Fed) to cut interest rates. However, there have been signs that the Fed’s string of rate hikes may finally be bringing inflation under control. Monthly inflation was flat in May—its lowest level since July 2022—which helped push the year-over-year inflation rate down to 3.3% from 3.4% in April.
The Fed kept the fed-funds rate steady at between 5.25% and 5.5% at its June meeting and showed signs that it’s in no hurry to lower rates. In a news conference after the meeting Fed Chair Jerome Powell said, “We’ve made pretty good progress on inflation” but also noted that “we’ll need to see more good data.”
Looking ahead, we believe the Fed will make its first rate cut in September. But there also will be a large amount of data—on the labor market, inflation and producer prices—that will come in between now and the Fed’s September meeting that will ultimately be the deciding factor.
Elsewhere, GDP for the 20 countries that comprise the eurozone in the first quarter grew 0.3% quarter-on-quarter, snapping a two-quarter contraction. Meanwhile, eurozone headline inflation came in at a 2.6% year-over-year pace in May, which was higher than the 2.4% pace it registered in each of the previous two months.
On the rate-cut front, the European Central Bank (ECB) was the first out of the gate, slicing its three policy rates by 25 basis points in June after more than nine months of holding policy rates steady. However, the overall tone of the press conference was on the hawkish side, signaling the ECB is not on a pre-determined easing path.
Global corporate credit research overview
Stable economic environment in developed markets led by moderate growth in the US, more modest growth in Europe and continued disinflation globally
Cracks in the consumer are developing particularly among lower-income households
Interest-rate-sensitive sectors continue to see demand but are vulnerable to rates staying higher for longer
Lower-quality companies with near-term maturities and limited access to markets remain a concern
Given the economic backdrop, we expect economic stability and growth to continue, albeit at lower levels, with sustained earnings growth. Balance sheets will likely remain healthy, contributing to continued stable credit fundamentals across most sectors. The election cycle in Europe (e.g., France) and the US will be closely watched, with potential implications to fiscal, legislative, global trade and regulatory priorities.
Having said that, higher rates and the cumulative effect of inflation will likely impact the consumer particularly at the lower end. The explosion of demand for services by the consumer has broadly slowed and cracks in consumer purchasing activity have developed. Lower-income cohorts have been impacted by rising borrowing costs and tightening lending standards, driving reduced spending activity highlighted by lower foot traffic. At the same time, higher-income consumers have also become more cost conscious with increased purchasing activity at higher-value/lower-cost retailers. Wage inflation and unemployment levels have broadly stabilized, but both could experience pressure as job openings continue to decline.
While supply chains have normalized, inventory levels have been slower to build back up, as was expected in the first part of the year. Still, expectations remain that we will see increased inventory levels in the second half particularly in the industrial sectors.
Similar to the slower-than-expected recovery in inventories, China remains a headwind for many industrial companies, including those exposed to commodity prices in the chemical, metals/mining and energy sectors. Interest-rate sensitive sectors such as housing and autos continue to rely on increased incentives, but demand in both industries remains solid. Financials have stabilized following difficulties in US regional banks and Credit Suisse’s failure last year. Consumer credit profiles and commercial real estate loans remain in focus, but larger firms are generally well-positioned and able to manage exposures. The multi-year buildout of data centers will likely have implications across a multitude of sectors, including technology, power generation and energy, basic materials (notably copper), construction and capital markets.
Leverage ratios for corporate issuers and capital adequacy levels for financial firms are healthy across most sectors, though interest coverage ratios and cash balances are expected to continue declining from recent highs, notably in the levered credit markets.
The visible mergers and acquisitions (M&A) and leveraged buyout (LBO) pipeline remains subdued due to higher financing costs and increased regulatory scrutiny. Similarly, the higher cost of debt has limited any pressure from activist investors. As a result, those with strong free cash-flow generation and well-positioned balance sheets may shift some capital allocation toward shareholder-friendly activities while maintaining appropriate credit metrics.
We expect balance going forward between rising stars and fallen angels, though within high yield we expect downgrades to outpace upgrades. In a higher-for-longer interest-rate environment, companies with near-term maturities are becoming more concerning, particularly for those with the lowest ratings that may have limited market access. Overall, we are constructive on credit fundamentals, but note areas of concern stemming from the impact of higher interest rates.
Fixed income outlook
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