Though there was certainly some weakness in widening credit spreads, rising UST yields drove most total return losses in fixed income year-to-date. We believe that this outcome has created a path for longer-term tailwinds for IG credit going forward. First and foremost, even if there is a recession, the probability of default for IG issuers is very low. What this means for higher-quality fixed income sectors, like IG, is that investors from this point forward will get the benefit of higher yields and duration as a potential defensive mitigator to any possible spread volatility if the US economy enters a recession. In a recession, UST yields will likely rally, which can provide a big positive boost to total returns. Moreover, it would help offset any potential weakness from widening credit spreads, as shown in the table above. The range of outcomes where IG credit investors could potentially lose money from today’s starting point has lowered considerably. This is not to say that spreads won’t widen; they can widen significantly if we enter a recession. But we have reached a point in time where investors can play both offense and defense through their allocations to US IG corporate bonds. We believe the defensive benefits of higher UST yields can materially offset credit spread weakness going forward. Fixed income is finally delivering income!
Credit spreads have widened since the beginning of the year and remain above five- and ten-year averages after hovering near historically tight levels for most of 2021. In terms of fundamentals, muted consumer demand, higher input costs and a strong US dollar have negatively impacted corporate profitability. However, balance sheets remain generally robust, providing most IG corporates with more financial flexibility to navigate a period of slowing economic growth, in our view.
Overall, we believe that yields in the asset class are better, and the risk-reward balance of current valuations has improved materially compared to the start of the year. This makes IG corporates a more attractive place for investors seeking relatively safe income. However, due to ongoing market uncertainty, slowing growth and deteriorating fundamentals, we acknowledge spreads can go wider and are certainly up in quality today within our US IG allocations to preserve liquidity and take advantage of any potential volatility in markets.
Interest rates likely to remain higher for longer
Given a very uncertain environment, it is likely that volatility will remain high over the foreseeable future. Increased levels of volatility are driven by limited visibility into the Federal Reserve’s (Fed’s) policy tightening path, for one, as investors keep hoping for an earlier pause in policy rate hikes and some are expecting rate cuts in late 2023. Our view is that rates will go higher than markets anticipate and stay higher for longer. Secondly, since Fed Chair Jerome Powell appears more concerned about not tightening enough rather than overtightening, we do believe a shallow recession is likely over the medium-term. However, this doesn’t appear to be priced into earnings estimates. In times of increased volatility, higher-quality credits with strong fundamentals and less sensitive end-demand are likely to outperform. We are therefore pushing more of our portfolio risk into non-cyclical sectors and still believe the US financial sector has strong risk-adjusted return potential given elevated spreads and very strong capital levels.
Coping with challenges ahead
Looking ahead, companies are going to face some challenges. Margins are likely to continue to feel the squeeze from elevated labor, financing and input costs. Corporates are already feeling the effects of significant wage increases as evidenced by the first layoff announcements from various technology companies. While companies are still benefiting from interest costs that have hovered near generational lows for more than a decade and have frontloaded borrowing, rising rates will certainly bite into the broader macro economy from both consumers to future corporate borrowing needs. Also, though we have seen improvements in supply chain issues, inflation will most likely stay higher, even if it stabilizes or retreats, and for longer than consumers or markets are accustomed to. This will continue to impact global growth.
Considering our expectations for a potentially challenging market environment over the near to medium term, we believe that cyclical consumer-focused industries and companies with high levels of exposure and sales to weaker markets, such as Europe, will likely underperform. We are also less excited about commodity sectors; although fundamentals are decent and commodity prices may hold up, valuations are stretched to us. Weaker economic growth can and certainly should cause spread volatility in these sectors as aggregate demand slows.
