Corporate health: A fa?ade?

Bernard Laliere "Even as the spectre of inflation slowly recedes, a new fear looms on the horizon. Beneath the fa?ade of an economic revival, there are worrying signs of stalling growth."

Inflation has kept markets in an iron grip in 2023, but has slowly started to recede — with central banks around the world signalling an end to aggressive rate hikes. This shift in monetary policy, reflecting a balance between fighting inflation and ensuring financial stability, is reflected in the markets’ expectations, which foresee three rate cuts by July 2024, both in Europe and the United States. The Fed's clear indication of an end to its hiking campaign, alongside reports of slowing inflation and cooling labour markets in the US, paints a seemingly positive picture. But even as this news has buoyed bond markets over the past months, a new fear looms on the horizon. Beneath the fa?ade of an economic revival, there are worrying signs of stalling growth.

Global leading indicators for both the manufacturing and service sectors are pivoting towards negative values. Similarly, business leaders' surveys are becoming less positive. Economies are currently riding on their previous positive momentum, but for how long? The expected impact of slowing demand and tightening financial conditions could swiftly alter market narratives.

Meanwhile, in Europe specifically, we notice that euro-area inflation figures are improving. Even so, the weakening of German economic data could suggest underlying structural issues in one of Europe's largest economies. Despite the optimism over rate cuts signalling a plateau in financial tightening, one must consider whether investors are adequately prepared for a possible economic slowdown.

But even as we navigate through these complexities, there are positive aspects to consider. The impressive bond performance in recent months, combined with overall attractive corporate bond yields, suggests a valuable opportunity to lock in these attractive yields and capitalise on potential capital gains.

Corporate resilience is also notable. Strong corporate margins, substantial cash reserves, and a general avoidance of re-leverage during the recent cycle paint a picture of robustness. Still, there are some notable distinctions among corporates, especially in sectors like supermarkets, which are subject to intense competition and have limited pricing power — illustrating the disparities in resilience and financial health across different corporate sectors. While these dynamics could have varied implications for different types of businesses, overall, corporates seem far better prepared than in previous slowdowns, thanks to cautious financial strategies in response to global challenges like COVID-19 and the war in Ukraine. But how will this resilience translate into investment opportunities, especially considering the disparities among corporates?

Clearly, a focus on credit selection will be one of the key investment factors that’ll drive performance in 2024. The disparity in corporate resilience underscores that not all investment opportunities are created equal — emphasising how performance drivers in 2024 will hinge on discerning credit selection.

Within the credit space, investment-grade bonds are particularly appealing, with the overall creditworthiness of investment-grade credit issuers on an upward trajectory, evidenced by a greater number of rating upgrades than downgrades. With a healthy spread over the risk-free rate, they combine healthy balance sheets and balanced maturity profiles.

The high-yield space, albeit more volatile, offers a decent credit premium for selected issuers who have maintained or improved their credit profiles. With careful selection, high-yield investments can mitigate credit risks significantly. Assuming moderate defaults, companies' ability to pay coupons should not derail credit market returns in 2024.

In the absence of major M&As or LBOs, the need for new issuance might be reduced compared to previous years. Corporates will first roll over their debt to benefit from a better rate environment than last year’s but will not start increasing the leverage due to the current economic uncertainties.

The technical backdrop remains supportive. Attractive yields, coupled with strong investor flows into both investment-grade and high-yield asset classes, highlight the enduring appeal of credit. With corporates likely to roll over debt at better rates and avoid increasing leverage, the outlook for credit markets seems promising — even in the face of economic uncertainties. But as always, the key lies in strategic selection and an acute awareness of the evolving economic landscape.