Corporate fundamentals: Entering 2023 in a position of strength
Early 2022 saw levels of revenue growth that were high to the point of being unsustainable. In both Europe and the US, earnings returned to a more moderate run rate of 9% and 8% year-on-year (y/y) respectively in Q3 2022. Positively, the overall growth rate is still above long-run averages. Despite an inflationary environment, margins have remained stable in Europe at 13%, triggering further improvements with net leverage falling to 1.7x, below the pre-COVID-19 level of 2.1x. Operating margins for US investment grade (IG) declined slightly to 14% and net leverage has risen slightly to 1.9x but remains below its pre-COVID-19 high of 2.2x.
On a sector-by-sector basis, the number of industries where the fundamental outlook is negative is exceeding those with a positive view for the first time since before COVID-19, suggesting some caution is warranted as we move into the new year. Despite this, we see opportunity in a number of sectors and have conviction in high-quality names.
Looking forward, IG corporate health remains in a relatively robust position. Historically in the later parts of the cycle, corporate debt growth begins to rise sharply, creating challenges for credit investors as they attempt to navigate the downturn. Since the COVID-19 pandemic, company managers have continued to adopt a conservative approach to managing balance sheets and have subsequently limited overall debt growth. Regardless of the economic reality of 2023, IG corporates have entered this year in a position of strength with some of the lowest gross debt growth since the Global Financial Crisis.
Dodging downgrades
During recessionary periods, investors need to be mindful of potential “fallen angels” – issuers that are downgraded from investment grade to high yield following a deterioration in their credit fundamentals. Since 2000, IG credit has undergone nine credit bear markets. Historically during credit bear markets, on average 4% of the US investment grade universe has been downgraded to high yield. However, not all downgrade cycles are made equally.
During 2020, the level of downgrades has been relatively muted as loose monetary policy and generous fiscal programmes have helped mitigate the impact on credit markets. In the coming downturn, the total number of downgrades could look closer to the long-run average of 4% as stubbornly high inflation prevents policymakers from significantly easing financial conditions. However, strong corporate balance sheets are likely to make IG credit more resilient to an economic downturn despite limited policy support.
A technical glimmer of hope
A theme with potential to continue into Q1 is the return of inflows to the asset class, as some of the highest all-in yields since the summer of 2009 offer an attractive entry point.
Over the course of 2022, US IG has experienced total outflows amounting to $157bn over the year, according to EPFR, as of 31 December 2022. Since 2010, there has been significant relationship between retail flows and returns. When returns turn negative outflows typically follow but when returns begin to look positive again investors typically come back to the asset class.
However, as of mid-December 2022, inflows have shown some signs of bucking this historic trend as the attractive all-in yields have offered investors a more interesting entry point into the asset class. If this trend continues, it should offer a more stable technical backdrop for IG corporates in 2023.
Chart 1: Percentage of US IG index downgrade to high yield during credit bear markets
Source: JPMAM, Barclays
More spread widening to come?
While all-in yields do look historically attractive, investors need to be mindful of volatility in spreads as we approach the later part of the economic cycle. Once the US Treasury curve inverts (typically measured by the 2s10s spread), corporate spreads can trade within a wide range, but they typically do not peak until the economy is in recession. Currently, spreads in the US IG market are pricing in a relatively low probability of recession suggesting that as growth slows, spreads may widen further from here, but it may take some time for markets to adjust to the economic reality.
In this environment, opportunities might also lie in taking advantage of the current shape of the yield curve to implement carry-and-roll trades.
In Europe, the 10-year and shorter portion of the euro corporate bond market look attractive. Meanwhile in US IG, the five-10-year part of the curve screens particularly well. Moving into 2023, we think there are opportunities to be found in IG corporates.
Enhance your core: JPM Corporate Bond Research Enhanced Index (ESG) ETFs
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This article was first published inFixed Income Unlocked: After The Storm, an ETF Stream report
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