Sound macro, attractive all-in yields and favourable technicals will continue to drive investor demand in fixed-income assets. Credit spreads have remained remarkably resilient so far, driven by the solid macro picture in the US and the improving outlook in Europe led by the services sector. The significant repricing of rate cuts over the last five months has had no impact on risk markets, as in large part this was due to receding recession fears.
Spreads only tend to widen when a real rate surge is accompanied by other negative factors, namely sub-trend growth expectations. The recent macro dynamics, reinforced by better-than-expected 1Q24 GDP data in the EZ, have helped to consolidate the risk-on sentiment as the dominant market narrative, pushing for a soft-landing with no recession, also supported by a constructive earnings season in Europe.
Higher rates yields with the growth backdrop have been positive for credit demand. With much of the credit investor base focused on yield buying, spreads have benefitted from the rate impact on all-in yields. In any event, investors appear to hold overwhelming convictions that there is a single scenario to consider for growth (the up/soft-to-no landing narrative) and interest rates (the down/disinflationary narrative), which we think, for the time being at least, will continue to be the dominant narrative, although we see more frequent bouts of volatility in the months ahead, driven by broad monetary repricing or increasing energy prices as a result of geopolitical tensions.
To sum up, credit spreads remain well behaved against a backdrop of hotter-than-expected inflation and continued rates volatility. This will likely remain the case unless it appears that further rate hikes are needed or an unexpected growth weakening. Even if yields were to get close to last year’s peak, we do not think it would change the positive narrative about credit unless and until investors start to worry about the Fed needing to hike policy rates again, which we think is still some distance away, with ‘high-for-even-longer’ a more likely outcome. The path of least resistance continues to be tighter credit spreads.
Credit spread dynamics we expect to see in 2Q24:
- Euro IG corporate bonds compressing further to USD IG peers (10-15bp still to go we think). The maturity of the Euro IG market is half that of its US peer. However, Euro IG spreads are still almost 20bp wider on a G-spread basis. With ECB cuts ahead, we think Euro IG corporate bond spreads should compress vs. USD IG spreads. As such, the EUR iBoxx IG Corporates should end 2024 in the 100-110bp range on a G-spread basis.
- EUR currency weakness helping spreads for “exporter” firms (cap goods and consumer sectors have historically done well amid euro/USD depreciation).
- Reverse Yankee issuance is becoming more prevalent. The YtD issuance (EUR74bn) suggests 2024 is on track to being the biggest year in terms of the supply of Reverse Yankees since 2019.
- Longer-dated bond issuance in Euro credit leading to steeper spread curves.
- We are in a carry-friendly scenario: low-duration/high-carry assets should perform well, e.g., the 3-7Y area of the IG curve.
- Buy-the-dips. Another source of returns in the months ahead in a credit-friendly backdrop is disciplined dip-buying. The recent rise in geopolitical risk did contribute to some limited spread widening, but geopolitics tend to have a limited impact on markets unless they end up damaging the global economy, which is a high hurdle. The rates market may complete the removal of cuts from 2024 (‘no cuts’, the UST2Y around 5.2%) which could also drive some position unwinding in credit. In our view, any rate move short of pricing in rate hikes would be a buying opportunity.
- Tight EUR banks SNP-senior NFC spread premium: The 'yield' edge of the IG Financial sector over its Non-Fin peers has waned dramatically, dropping from near 1% in 1H23 to only 0.2% today. Non-Financials should, in our view, benefit more than financials from potential upside economic surprises in the EZ. Despite the still-strong 1Q24 earnings season by EUR banks (70% of positive surprise on reported earnings with an average upside of around +8%, a 'higher-for-(even)-longer' scenario on rates does not longer look particularly supportive for Banks from a credit perspective, as margins will be hit bit by higher costs while, in the meantime, we might see a rise in the NPL ratio as corporates with weak balance sheets could suffer from a potentially extended period of high funding costs.
- HY momentum weakening: Similar to subordinated debt, the EUR HY NFC segment broadly benefitted from the 'yield-driven' rally on the credit market, but all-in yields look far less attractive than before (6.17% vs. 9.0% in 4Q22). The premium gap with IG debt eroded at a very high pace (>250bp compression since the 2H22 peak) to reach a historical low level below 200bp in 1Q24, which does not adequately reward cost of risk. The HY rally seems to have reached some limits as we have witnessed a technical retracement in spreads since mid-March as a result of idiosyncratic default stories (Altice, Atos, Kemple, etc.). This should not matter as long as volatility remains muted, but if market conditions change this may well soon change.
What keeps us awake at night
Volatility regime. The continuity of the credit rally will in part depend on the absence of a major sell-off on both the equity and sovereign side. Low volatility would keep the 'carry' strategy alive, which has broadly benefited credit overall. Rising geopolitical tensions and idiosyncratic default risks could, however, urge investors to be more selective on the quality of names in their portfolios.
Although rates volatility has increased, it can only be truly unhinged by central banks putting rate hikes back on the table, which would effectively open up a completely new risk scenario, one that might very well end in a hard-landing, which is the bear case for credit, although the hurdle is high.
Idiosyncratic risks (CRE, the return of fiscal issues, elections, etc.). After the widening pressure on a pocket of German banks with significant exposure to US CRE, the headlines on this front have subdued somewhat in the last few weeks. Sovereign risks would likely reverberate on credit, notably on the sectors with a heavy exposure to French credits such as banks and utilities.
The timing of an equities correction: Equities remain significantly higher YtD and continue to hover around all-time highs, while credit spreads are trading at or near post-GFC tights. The equity trend, driven mostly by multiple re-rating, is disconnected from the significant increase in bond yields and repricing of the Fed following a streak of hot inflation prints. Equity markets may be more vulnerable to volatility than usual at the moment due to stretched long positioning, particularly in momentum stocks, and we see signs of exuberance in AI names and cryptocurrencies are also difficult to ignore.