Macro uncertainty is on the rise
The global economy continues to show signs of overall resilience, although downside risks are starting to appear. Global disinflation remains on track, and the normalisation of supply chains and the slowdown in China explains the disinflation in goods. Services inflation remains sticky, but the balance of risks is shifting to the downside. With the exception of the BoJ, most central banks are engaged in easing monetary policy, and the Fed has also started to do so with an unexpected – at least to some extent – 50bp rate cut.
Growth dynamics remain uneven across regions. Since COVID, global macro has been all about the US. Investors have laser-locked on the speed of the US recovery, the aggressiveness of its central bank, and the exceptionalism of its tech firms. The US economy is still converging to trend growth from higher, while Japan’s growth is bottoming and the UK is surprising to the upside. However, China is disappointing due to depressed domestic absorption, although the recently announced package of monetary and financial stimulus measures send a signal that policy coordination is improving and the Euro area remains the weakest link, although the slowdown is not broad-based (Southern Europe is more positive vs. Germany & France). Geopolitics and the US elections remain the most relevant risks due to the impact in terms of policy uncertainty, but we think that the fears of recession are overdone. A soft-ish landing is still likely if the world avoids a global trade war.
It is all about the US labour market now. Yes, downside risks to the labour market have increased, but we take solace from the drop in jobless claims, now at a four-month low, the confirmation of a solid rebound in Q2 (3% annualised) and the resilience of consumer spending. The recent increase in the unemployment rate has not been driven by mass layoffs, as in previous recessions, but by higher immigration (among several other factors). Robust consumer spending gives us further comfort, as the labour market and consumer spending would deteriorate in tandem if we were heading into a recession.
Monetary policy convergence to accelerate
With the Fed having commenced its rate cuts cycle in style with the recent 50bp cut in its September meeting, convergence is about to start. This cycle has been characterised by growth divergence and policy decoupling, particularly among the G10 central banks. While the US delivered above-trend growth, the picture was bleaker for most other economies. In our view, this led to a policy decoupling, but with more front-loaded Fed cuts, convergence will accelerate. At this stage, markets are betting on aggressive Fed and ECB easing cycles and are pricing almost six ECB rate cuts (160bp total) and eight by the Fed (190bp) in the next 12 months.
After the somewhat surprising 50bp cut by the Fed in its September meeting, which Chair Jerome Powell described as a “recalibration” of policy rates, rather than a sign of concern about the health of the labour market, we would expect 25bp sequential rate cuts going forward. In this regard, the dot plot was hawkish, and Powell’s message was broadly optimistic. The general tone of the press conference also tilted hawkish, pushing back against the notion that this would imply a series of 50bp rate cuts, and rejecting the idea that the Fed may be behind the curve.
At this moment in time, we align ourselves more with the rate cuts path shown in the September dot plot (two additional 25bp rate cuts in 2024, four/five more 25bp cuts next year and two cuts in 2026) than with the c.200bp of cuts up to YE25 that the market is now pricing in. We see a Fed rate of 3-3.25% by YE25 and a terminal rate of 2.75-3% by 1H26, in line with the FOMC’s estimate of the long run, or neutral funds rate, at 2.875%.
The ECB is following the script and showed little enthusiasm to cut again in October. We cannot say that the September meeting materially changed the perception of investors, and the jury is still out regarding where the ECB rate could be by the end of 2025, in the 2-2.5% range or perhaps faster cuts will be needed.
This lack of commitment implies that October will remain live given domestic and global conditions, but we still think the path of least resistance is to maintain the quarterly easing path this year, given the differing opinions in the committee. We see a potential case for a more accelerated easing in 2H25, but we would need to see a sustained undershooting of the 2% inflation target. In this sense, the market is pricing a more aggressive path as economic weakness is boosting monetary speculation and the odds of another ECB rate cut in October (>60% based on futures vs. <30% on 20 September).
Credit markets: lower rates and all-in yields in the way of tighter credit spreads, but this is still a bullish market
August was the worst month since March 2023 (+9.5bp in IG senior debt). For the Non-Fin segment (+9.0bp), we have to go all the way back to June 2022 to see a poorer performance, while for Financials it was the worst month since October 2023 (Italian/French budget).
The widening trend in EUR IG spreads since early August up to the Fed’s September meeting was driven by three main factors: (1) recession concerns; (2) strong supply (see primary segment); and (3) declining investor interest (outflows in the secondary market). A strong restart of primary activity – and the wall of redemptions that is looming in 2025 and 2026 (c.EUR 230bn and EUR260bn of Non-Fin IG senior debt), when the COVID debt repayment process starts – is certainly part of the conundrum behind the sluggishness of spreads.
The Fed’s 50bp rate cut has been a game-changer, and there are few significant catalysts until Non-Farm Payrolls on 4 October. Additionally, primary markets are already past their peak after an exceptionally heavy August and solid start to the month, and will soon begin to slow into quarterly blackouts. The US election is also still six weeks away, which is a little too early for investors to start setting hedges. As a result, in our view, it is likely that the positive mood music from this week will be carried over in the short term.
Our generally positive strategic view on credit markets into year-end is helped by rate cuts spurring more demand, we believe that two dynamics support recent market strength. The first is that with the Fed out of the way, the next FOMC meeting is not until 17 November (after the US election), and the ECB meeting in October is generally priced in as not being "live"; this leaves a significant amount of time (to bleed from being short/underweight) until the next identifiable macro event.
Another near-term supportive feature, at least for IG credit, is seasonality, as supply should slow down somewhat from here. Although we cannot exclude the possibility that issuers will keep tapping markets ahead of the US election in early November, we would expect some respite from a very active primary market. Moreover, the disinversion of the 2-10Y Bund curve for the first time since November 2022, on the back of weaker Euro Area PMIs, and ECB doves raising the spectre of another rate cut in October is good news for credit, as yields on “cash”-like products are falling quickly now versus yields on 7-10Y single-A and 7-10Y BBBs, for instance.
The combination of gradual rate cuts coupled with a stable economy that continues to grow – although very likely more slowly than expected in Europe – looks like perfect conditions for both equity and credit to keep rallying thanks to (1) the constant growth of earnings (i.e., solid balance sheets); (2) constant inflows fuelled by money market outflows as this segment will not be as rewarding as it used to be in recent weeks due to declining interest rates. Of course, such a soft-landing-related scenario would be challenged in the event of an economic slowdown and/or financial market events leading to more volatile conditions.
A soft-landing scenario on growth coupled with gradual monetary easing are goldilocks conditions for the asset class, as investing decisions are 'yield-driven' in a low-volatility environment and default risks are limited if earnings growth continues to improve (or at least normalise slightly after record years). It is the dominant narrative that has driven European markets for months and still seems to be the tune hummed by central bankers and economic consensus if we refer to current growth/inflation forecasts.
The main factor determining whether a spread-widening trend can be sustained in time is whether it can or cannot be quickly circumscribed. Previous periods when spreads continued to widen were driven by situations that took time to be resolved. For instance, the 2010 sell-off was driven by the European sovereign crisis, and the 2011 widening was sparked by the US sovereign downgrade, combined with another European sovereign crisis. Lastly, 2020 was driven by COVID.
In contrast, the situation did not deteriorate meaningfully in the 2022 and 2023 episodes. In the first case, the start of the Ukraine war surprised the market and pushed spreads wider. However, the market quickly decided that this did not represent a huge threat to the US economy. Furthermore, the market swiftly turned its attention to the Fed lift-off that took place only a couple of weeks after the sudden widening. The 2023 episode was linked to regional bank concerns and the Credit Suisse debacle. In the latter case, central banks intervened quickly to contain the problem, which reassured the markets.
No credit market is pricing a recession today. This said, Euro IG is relatively closer to pricing in a recession: 121bp on a G-spread level versus recession pricing of 155bp/160bp and EUR HY is a lot further away: BBs are at 229bp vs. 550bp recession pricing. In this regard, we see EUR IG spreads tightening to 105-110bp (G-spread) by YE2024, while we see EUR HY NFC trading around current spread levels, 280-290bp (350bp in G-spread) vs. 296bp as of now.
Regarding US credit spreads, our constructive stance would imply investment grade spreads to trade to 95-100bp (vs. 106 bp as of 24 September) and for high yield to trade between 290bp and 315bp going into the election (vs. 320-330bp now).
Safe and Senior credit is cheapest across EUR IG. Virtually everywhere we look within IG we see asset class compression, in defiance of the rates rally and slowdown risk. Cash price vs. spread product is exceptionally expensive, as is Cyclical vs. Non-Cyclical, and BBB vs. single-A. With the market expecting the Fed to start cutting in September, we think this is a good time to add duration.
We expect a steady performance for corporate hybrids in the remainder of the year, particularly as primary activity should slow after September's peak. Indeed, corporate hybrids look attractive versus LT2, which are their closest proxy in risk-reward terms within the hybrid capital universe.
The Fin/Non-Fin senior spread gap is at its lowest level since January 2022, below 6bp. We consider markets are currently overpricing recession risks and inversely underpricing budget-related risks in Europe (and especially in France) that will be negative for Banks (especially if rating downgrade debates return), and valuation is somewhat stretched. We nevertheless acknowledge that the short-term momentum looks more favourable for extending compression of the Fin/Non-Fin spread for some weeks until we see more evidence that the macro outlook in Europe is not as bad as the market fears.
As we move towards the US elections in November, we expect investors to become more picky on credit, particularly for industries and companies with economic models that rely heavily on external partners, given the increased risk of new tariffs and tit-for-tat retaliation measures. The pattern we have seen in previous US election cycles is for jittery markets in September and October, followed by a strong bull run in the November-December period. However, this historical trend might be different in the current election cycle.
To sum up, we believe that cash spreads will trade marginally tighter by year-end due to higher yields, but also because fundamentals do not present a significant headwind. The bottom line is that balance sheets remain in a good place, but interest coverage generally continues to deteriorate.
2025: A year of spread decompression
An initial look at 2025: We are not yet in 2025 but we can already make a prediction for next year: the rating of credit risk that had temporarily disappeared in recent years could resurface and drive investor decisions in a new environment that mixes softer growth with a weaker fiscal impulse.
We see a 2025 where liquidity risk is down and fundamental risk is up, so decompression should be the main trend. Liquidity risk is associated with monetary policy and the health of the financial system, and is primarily driven by central banks. It is an indicator of how credit markets are pricing in credit conditions. Changes in fundamental risk are usually driven by lagged changes in implied liquidity risk. If credit fundamentals worsen, fundamental risk widens. IG is usually more sensitive to liquidity risk (higher duration, rates-like asset), while HY is more sensitive to fundamental risk (lower duration, equity-like asset). Credit markets are likely to decompress in the coming months even in a soft-landing scenario. Credit conditions should ease, driven by rates, which should prevent a recession as the labour market remains in balance. However, the tail risk is not ‘too hot’ anymore but ‘too cold’.
Risks: Macro, fiscal, elections & geopolitics
For much of 2024 we have focused on all-in yields as a driver of demand and performance, offsetting otherwise tight spreads. Having said this, all-in yields are much lower than they’ve been all year; sub-5% for US High Grade and closer to 7% than 8% for US High Yield (and below 3.5% in EUR IG, and below 6% for EUR HY for the first time since 2022) in a context where the US election is six weeks away. There is also the event risk associated with higher deficits, tariffs and trade wars, and the shadows these might cast over the 2025 macro outlook. Right now, it is unclear how to position for this when the outcome of the US presidential election is unknown, yet non-recessionary growth is such that defaults and delinquencies remain benign, and there is enough disinflation to allow central banks to deliver lower policy rates etc.
Geopolitics is an unpredictable factor. Second-guessing the US election, especially with recent polling well within the margin of error, feels unintuitive. But there are policy implications: in particular, a resumption of trade tensions is an overhanging risk. The months before US elections are typically risk-off as political uncertainty rises, followed by post-election rebounds. Furthermore, with Middle-East tensions, elections for the German chancellor in September 2025 and the French political situation still up in the air, it is reasonable to expect an ongoing premium for geopolitical uncertainty.
The biggest tariff concerns could pose a material headwind to credit markets, especially when coupled with other underlying macro worries. For instance, the effect of the China trade tensions in 2018-19 was exacerbated by worries about growth and Fed policy errors. This is bad news for credit if these doubts materialise and bury the soft-landing/higher-for-longer narrative on growth/rates that has driven decision-making for months.
We highlight three potential headwinds for credit spreads: (1) markets pricing in more rate cuts (by the year-end) than our estimates, both by the Fed (80bp vs. 50bp) and the ECB (47bp vs. 25bp); (2) declining flows into the credit space, as rate cuts will mechanically reduce the carry trade that has mainly been supported by retail investors, while it could also trigger some arbitrage from high-rated corporate credit into the sovereign space in the event volatility remains elevated; and (3) equities, as cuts that have been followed by a recession have unsurprisingly resulted in negative S&P500 performance, in contrast to returns in the high teens outside recessions. It is also worth noting that the equity market 12m performance in the run-up to the first cut historically averaged just 4%, vs. the current very strong 25%.
French risk premium burden amid a still uncertain political landscape. Thus, while Michel Barnier's appointment as Prime Minister clears some political uncertainty, the frailty of the incoming government implies meaningful fiscal consolidation is unlikely. The French risk premium has not improved much (the OAT/Bund 10Y gap is still above 75bp) as the next government still has massive challenges ahead of it. There are risks of a further deficit slippage in 2024, which could reach up to 6% of GDP vs. the 4.4% estimate set at the start of the year. The risk here is distrust from foreign investors, who could decide to cut their French exposure and/or reduce their purchase of French assets (notably French debt) ahead of the forthcoming rating agency reviews. At a country level, France is the biggest IG & HY issuer, representing 20% & 16.5% in iBoxx indexes, and at the sector level (the biggest issuer in Banks and Utilities, which are both very sensitive to sovereign risks, representing 23% / 24%).
The US is the second largest EUR IG issuer (15%) behind France (21%), thus the US and its macro/micro outlook has a major influence on European credit. The US has the largest relative share in the EUR iBoxx Media (35.5%), Telecoms (25%), Tech (52%), Healthcare (36%) and Food & Beverage (25%) sectors.
Germany’s macro blues. The German economy has been heavily impacted by: (1) the end of the cheap energy era due to the Ukraine war; (2) weak Chinese consumption (lower demand for Western goods); and (3) oversupply due to excessive output from China in some industrial segments (e.g., solar panels, chemicals, EVs, steel), amid fresh political tensions in relation to budget composition.
Further weakness in German economic momentum would weigh on the performance of sectors with significant exposure to Germany, such as Travel (German issuers are number one in terms of amount outstanding at 40%), Autos (Germany is number two at 25%), utilities (Germany is number three at 12%) and chemicals (Germany is number one at 23%). In this regard, we see increasing evidence suggesting that Germany will enter into recession in 3Q (business confidence dropped to an eight-month low in September, while manufacturing sentiment slumped to a four-year low). Germany accounts for 10% of the total EUR IG credit at the senior level (the third most behind France and the US).