Macro Markets Podcast Episode 44 Transcript: Corporate Credit Review and Preview
Maria Giraldo, Investment Strategist, discusses the performance of the corporate credit sector this year and the rationale for our cautiously optimistic outlook for 2024.
Jay Diamond: Hi, everybody, and welcome to Macro Markets with Guggenheim Investments, where we invite leaders from our investment team to offer their analysis of the investment landscape and the economic outlook. I'm Jay Diamond, head of Thought Leadership for Guggenheim Investments, and I'll be hosting today. We are recording this episode on November 24th, 2023. Well, it's the Thanksgiving holiday week, so things are fairly quiet. The economy seems to be in a sweet spot of not too hot and not too cold, which means both bonds and stocks are having strong months. But we all know that these kinds of economic conditions don't last long and are only a waystation on the way to either more strength or more weakness. It's therefore a good time to stop and talk about where we have come from and where we might be going, and there's no one better to tackle this topic than Maria Giraldo, Investment Strategist and a leader of our Macroeconomic and Investment Research team. Welcome back, Maria, and thanks for taking the time to chat with us today.
Maria Giraldo: Thanks, Jay. It's always a pleasure to be here.
Jay Diamond: Well, great. Well, to begin, Maria, in a nutshell, what's your current view on investing in credit?
Maria Giraldo: I think the punch line for me right now is yields really present a great opportunity, especially because we're reaching this turning point in monetary policy where the Fed is shifting from hiking, to a pause, and then there's still another turning point ahead when they shift to easing or lowering interest rates. I don't think many investors have considered what total returns could look like in 2024, given where yields are starting off and more so in an environment where the Fed is easing, whether it's due to a recession or even not due to a recession, but rather as a result of winning the inflation fight without the recession. We’ll get into that more so later, but let's just say the double digit returns in fixed rate credit is certainly possible, especially if you're in the camp where the Fed is going to be lowering interest rates. So, to sum up, I would say that we are cautiously optimistic right now on fixed income and on credit.
Jay Diamond: We have to unpack that a little bit. So we're coming up on year-end. And it seems 2023 has been a year of resilience for the US economy and, more specifically, the U.S. consumer. How would you describe the credit landscape in 2023 as that resilience made its way through to what you're seeing in credit fundamentals?
Maria Giraldo: Yes, there are elements of consumer resilience as a theme that have passed through to credit, and mainly it's been through corporate earnings. If you look at consumer discretionary as a sector, which has done really well in the S&P 500. That sector earnings per share growth is tracking 45 percent growth on a year-over-year basis. I say tracking because we don't have Q4 earnings just yet. We're not going to have that until February of next year. But this tracking estimate is a culmination of results so far for the year plus Q4 expectations. Consumer discretionary is a broad category, includes hotels, restaurants, leisure, autos, areas of more specialty retail, household, durable products, just pretty broad. But again, it's picking up that consumer resilience.
Another sector that has done well as industrials earnings per share, they're up 13 percent. It's a sector that tends to move cyclically, so includes companies like Boeing, General Electric, Caterpillar, as well as airlines, Southwest, American. Again, it has shown consumer resilience, and its flow through to corporate earnings.
For comparison, the S&P 500 earnings per share growth for this year is trending about 1.6 percent growth for the year. And what's weighed on it has really been commodity sectors like energy and materials and even to some extent health care, which has struggled in this inflationary environment, but then also as demand fell post-pandemic. But the fact that energy has lagged is reflective of the macro environment and drivers of consumer resilience this year. Ultimately, how has this flowed through to credit fundamentals? Well, they've been good. Leverage ratios have been increasing a little bit, interest coverage has been deteriorating, but it's still in a better state than where they were going into previous recessions or even other periods where we may have been more defensive, like in 2019. So, for example, back of the envelope threshold, at which we would be really more concerned about credit quality in the high yield market is when the sectors generating less than two times interest coverage. That means that annual cash flow only covers annual interest expense by just two times over. It's a threshold where you don't have a lot of flexibility, or you're really at risk, or vulnerable to a temporary setback. And basically at that stage, historical studies have shown that there's not a lot of levers to pull to ride that out for a bit. But the latest fundamentals show that the market in aggregate is still covering its interest expense by three times over. So, there is enough cushion. Now, much like what we're seeing in the broader economy, you can't undermine the dispersion that we do see underlying those corporate fundamentals. There are indicators that we track that suggests that companies with the strongest fundamentals are masking those with weaker fundamentals, if all you're looking at is high level data. Now, what's what I think is really interesting about that is that we see the same in different aspects of economic data, including, interestingly, the labor market. The lot of strength in non-farm payroll growth, for example, recently has come from job gains in government, in health care related job growth. Those are two sectors that are really giving us a macro signal about where we are in the cycle, and it's instead masking weakness in more cyclical sectors like temp work or in trucking. So, it's just really interesting. There's a lot of elements, macro themes and such that we see at a macro level and are working their way through to the micro level within credit.
Jay Diamond: What would you say some of the things were that you got wrong in your 2023 outlook?
Maria Giraldo: I really like this question. I would say that we at Guggenheim like this question a lot because it forces us to evaluate drivers over our base case views, ensure consistent application of our frameworks with which we're thinking ahead. And in that reflection, I would say that we got the timing of our recession call wrong. We called for a recession to begin sometime around the middle to second half of this year, and that hasn't materialized. Now, I wouldn't go as far as to say that we've been wrong about this tightening cycle causing a recession. I just think the jury is still out. So, thinking about why the timing was wrong is because there are drivers in this cycle that are super unique. We are big students of history at Guggenheim and know that the sheer magnitude of the liquidity injected into the U.S. economy since the pandemic combined then with stimulative fiscal policies at a time when the Fed is trying to fight inflation, then also in a non-recession period, those are just not things that we can study in history, and it just hasn't happened. So, it was unclear how much of the liquidity needed to be drained from the system. Was it all of it or just some portion enough to cause a recession? I think we're learning based on consumer behavioral patterns that all of it needed to be drained or at least a substantial amount of it.
Separately, one area that I think we underappreciated, I would say, is the impact to consumption from the decline in energy prices, because it was clear that national gas prices at the pump had fallen from $5 a gallon at the height in 2022 to $3 by year end. And that's not data that's going to get revised. And it actually allowed consumer budgets to free up. for on other things in 2023. Now, on a going forward basis, those factors won't exist anymore. We're not going to have another decline in national gas prices by $3 a gallon, and there's now a lot of evidence that suggests that consumer excess liquidity is drying up, including personal bankruptcies and credit card delinquencies that we're seeing. We're also not going to have another year of fiscal stimulus in the form of a widening budget deficit, certainly not in an election year with a divided government. And it's challenging to see what the drivers are going to be next year to see GDP growth and consumption still come in above expectations.
Now, of course, getting the timing on the recession wrong meant that there were other elements of our calls that didn't play out quite as expected either. I thought that corporate earnings growth by now would be down 5 percent. Well, as I mentioned earlier, for the S&P 500 is tracking a little over 1 percent. And some of the more cyclical sectors have done even better. And then the other one is that we thought credit spreads would widen, and it did near the start of the year due to the regional banking turmoil. And now they're tighter on the year and credit has outperformed Treasurys instead.
Jay Diamond: Where were you correct? What were you right about in your outlook for 2023?
Maria Giraldo: So interestingly, the things that we were right about at a macro level as it relates to credit were also things that were more consistent with the early stages of what we'd see in a recession. The fact that we are in a default cycle now. At the beginning of the year, we published our High-Yield and Bank Loan Outlook that indicated our 3.5 percent default rate forecast for 2023, and that is exactly where the market has come in so far, between 3.5 to 4 percent. The other thing that we expected to happen was that we would see very negative rating migration, meaning more credit rating downgrades than upgrades, which is really challenging for credit portfolios. If you're trying to maintain a certain average credit quality on the portfolio, in some cases that could be driven by just regulatory requirements as an investor or just internal frameworks or guardrails for risk allocation. You could now be looking at your credit portfolio at year end with a lower credit quality than at the start of the year, unintentionally something that as an investor you didn't mean to do. And so ultimately what this means is that there are things we're right about and things that we were wrong about, but you still had to navigate this market carefully and in a way in practice for investment allocations and such, there's a lot of elements of the beginnings of a recession that you had to strategize around.
Jay Diamond: Okay, great. Let's talk a little bit more about what a default cycle would look like. Are there any elements of this default cycle that you believe are unique compared to other cycles?
Maria Giraldo: Yeah, there are very unique elements to this cycle compared to the last 40 years of default cycles. We’ve had at least three recession driven cycles in that timeframe. And then we've had a few that were more related to energy markets that were happening outside of a recession but related to oil prices coming down. But in any case, across all of these periods, the one unique aspect of the current cycle is that health care has been a sector with really high default volume, and that's challenging because it's typically considered a defensive sector. If you are trying to go up in quality and maybe you're thinking about that as let's move away from cyclical areas, that might be an area that that some credit managers might have taken more exposure to. But according to the S&P data tracking their default rates, speculative grade health care issuers have defaulted over the last 12 months at a rate of 13 percent. So, 13 percent of issuers in that space have defaulted. That’s actually pretty high.
Something else that's unique to recent default cycles, as I mentioned, energy has been one that has experienced at least two default cycles itself in the last ten years. And now over the last 12 months, the energy default rate is about 0 percent. So, what does this mean is that certain traditional playbooks have really not worked out. If you wanted less cyclical exposure, you've had to think about it very differently and much more nuanced than that in the past has been very credit specific. And to that point, there's sort of another element that's playing out in this default cycle. And let me go back to the idea that almost every default cycle historically has had a very soft spot, or maybe you want to call it ground zero or a broader theme. You had the 2001 tech bubble, 2008 housing and banks. and even though there were spillovers, you knew that those sectors were sort of like the ground zero. In this cycle, there really hasn't been a ground zero, and that's tied to high interest rates and inflation are indiscriminate stresses. The affect everything and everyone, either via first order or second order effects. And ultimately if I'm looking for a theme, it's just come down to cost pressures and margin strength. As a company, did you have the ability to pass through price increases in order to protect margins? And then also because the lending environment is so strict, have you been able to survive without borrowing more? We've seen that debt amongst U.S. corporates is very flat. It really hasn't grown and not everyone can weather that type of environment. Some companies relied year after year seeing rates decline, which means they could go in, refinance at a lower rate, free up some cash flow from interest expense, and even add a little bit more debt to the balance sheet. That dynamic was interrupted with the Fed fighting inflation, and we really saw that there were companies that used 30 years of declining rates as its lifeline.
Now, there are other elements too. Secular changes like work from home over office that's putting pressure on companies’ survivability, obviously WeWork being the prime example there. But internally how we used to describe this default cycle is by its idiosyncratic nature. Yes, to some extent, there are macro factors involved, like higher interest rates, but then that really needed to meet the right combination of company specific problems, that meant that they couldn't survive this environment. And it's something that I expect is going to continue as we look out to 2024.
Jay Diamond: You mentioned inflation. What are some of the inflation trends you're seeing now among U.S. corporate borrowers? And are there any signals that you're picking up from the data?
Maria Giraldo: The signals that we're picking up are that inflation pressures have come down a lot. We are looking at survey-based data, for example, coming out of the ISM or S&P surveys. We can see that fewer and fewer companies are citing inflation as a top problem, or at least they're citing certain costs as a driver for continuing to raise prices, they're citing those as no longer a problem. For example, companies saying that energy prices is a reason they need to keep raising their own prices. That's back down to where we were in 2019. Same thing for raw materials. Nobody's really citing raw materials as a reason to keep passing through more price hikes and then strong demand, too, was another big reason before they would say, “well demand is strong enough that it seems even if we raise prices, we won't cause that demand destruction.” That's no longer the case.
Now, actually, measures of demand suggest that they see material weakening. There was a Bank of America research chart that even showed that mentions of weak demand in corporate earnings calls amongst consumer sectors are now at recessionary levels. Now, up until recently, rising labor costs was still cited as a big reason why companies might be trying to raise prices. But in the latest couple of S&P Global PMI surveys, that reason has collapsed, too. But I don't think it's so much that labor costs have come down. Actually, various measures of wage growth suggests that it's still over 3 percent or even over 4 percent, which doesn't sound like a lot. But when you have labor costs rising by just 2 percent on average in the last ten years preceding the pandemic, it's a big adjustment for companies. I actually think the real element that's playing there is the fact that companies are losing their confidence about either being able to pass through more price hikes because now they are more worried about demand destruction, and this is going to be a problem for 2024 because revenue growth is slowing a lot. In the S&P 500 I calculate that revenue growth on a year over year basis has been only about 2 to 2 and a half percent. So, if you compare two and a half percent revenue growth to potentially still 3 percent compensation growth, all of this is going to mean more margin pressure next year. And that's part of an element that I think is going to drive still weaker than expected corporate earnings growth, but I think if you're looking for a silver lining, it's that at least inflation is going to come down.
Jay Diamond: If you are credit investor, how have you performed and how does it compare kind of sector to sector?
Maria Giraldo: I guess starting with the safest areas like Treasurys. In Treasurys, the return has been roughly 0 percent. That means that prices have gone down enough to offset the yield on a Treasury bond at the start of the year. It's not ideal. At least you haven't lost money on a mark to market basis. But what's happened is interest rates have gone up and many of us who [are in] finance and even those not in finance know if interest rates go up, your bond prices go down. So that's what's happened in that sector. And when you go to investment grade corporate bonds, your return profile looks a little better, but it's 2.6 percent higher. Better than Treasurys, partly offset by the duration profile of the index, also partly because you're getting additional yield over Treasurys or the spread, as we call it. When you start to get into riskier assets or what we call higher beta, your returns this year look more attractive. In high yield, return is about 8.1 percent, and in leveraged loans, it's about 11 percent, both driven by the fact that yields were attractive going into 2023 and that in this environment, shorter durations have really helped protect from the rate volatility that caused price declines in other sectors like Treasurys and investment grade corporates. Let's get into even, I guess, even higher beta, equities. The S&P 500 has returned 20 percent, but a lot of that upside this year really came from what investors call the Magnificent Seven. Those are the large tech-related companies, Google, Apple, Amazon, Meta, Microsoft, Nvidia and Tesla. They represent half of the weighting in the Nasdaq. But when you take those out, let's say we just equally weight the S&P 500 index, then the return is only 3.5 percent. And when we look at small caps as well, Russell 2000 return has only been 1.5 percent. A lot of people, maybe they don't care that a lot of the upside in equities came from a small cohort when I could also find companies that are not the Magnificent Seven that have generated 20 percent plus returns this year. But I do think it all of this goes to show a couple of things. One is that fixed income is performing as it's expected. Providing this cushion for returns for prices potentially going down a little bit more if rates go up, the income portion is providing enough cushion that you're sort of protecting your principal. And the Treasury market, you see no change in investment grade, eked out a little bit of positive return, but is providing a little bit more of that stability. The other element of what returns across these sectors are showing for 2023 is that yes, it's been a good year for risk assets, but you still have to pick your spots. Same went for high yield and loans, whereas I mentioned earlier, ratings have been cut often and defaults have gone up. You still have had to be selective.
Jay Diamond: The future is really what matters for investors, and you've done a great job of explaining how we've got here on a return basis, but what are your expectations for returns for next year?
Maria Giraldo: Well, this is the part that I mentioned earlier is underappreciated by many investors. Because they see 5.8 percent yield in investment grade bonds, 8.5 percent yield in high yield, and think, “well, that's great. Maybe I should allocate some to these areas of fixed income.” But equities returned 20 percent this year, so not quite as attractive in comparison. But here's the thing: part of what's driven equities higher has been that the market expects the Fed to start cutting interest rates next year, and we do as well. So, if that's the case, we think Treasury yields across the curve will fall more than the market is currently expecting. But again, as I mentioned earlier, yields fall, bond prices rise, and there's some areas in credit that have plenty of room for capital appreciation since average dollar prices in high yield corporate and investment grade corporates are ranging between 80 and 90 percent of par. If rates decline by, say, 0.5 percent and nothing else changes, your investment grade on return could be about 7.4 percent. And this is just based on the index, meaning those returns could differ a lot depending on what your rating allocation is and your duration profile and other factors. But nonetheless, you know, 7.4 percent return in an environment where the Fed is cutting, and rates are falling is already more attractive and more competitive outcome for investment grade credit than just going off of where yields are starting at 5.8 percent. Now, if you are a soft landing avoiding recession believer and think that spreads could tighten even more, you now get into more of an 8 percent range of returns or higher for investment grade bonds. In high yield, you're already in the 10 percent range of returns for just rates falling and no change in credit spreads. Now, if you're bearish on the economy and think that rates fall and spreads widen, you're probably more tilted to high quality investment grade. In most likely scenarios, you're generating solid returns because fixed income is performing as it should. That coupon and that yield is giving you that cushion. And also in most scenarios where spreads are widening a bit in investment grade, your all=in yield is falling. So that's generating positive returns.
Now, all of that might be a little bit too technical, maybe too much into in the weeds for some listeners. So the way I’ll round this out is by really saying that the only scenario where you'd want to stay very bearish on fixed income next year is if you think inflation will accelerate again and the Fed is going to hike another hundred basis points or more, which frankly is not impossible, it would just be very much an outlier from most people's views and also how we're reading the economy and the economic data right now. And the other scenario in which maybe you'd want to be even more bearish on credit is if you think something like the high yield default rate could get to 20 percent next year and investors would recover next to nothing on those, or if you think there is going to be more regional banking failures or something that the Fed would have to step in again, or maybe they would struggle to limit the spillovers, That’s something that would cause a lot of investment grade companies and financials in particular to lose their great status. In those scenarios you're underperforming Treasurys, so it wouldn’t be worth the risk. But the way that we see it, those are pretty low probability events.
Jay Diamond: How do you summarize your team's views on the macro economy for 2024? And how do you think it will influence your outlook for credit next year?
Maria Giraldo: We still see elevated recession risk. A lot of that is kind of flowing through from the lending channels that are tightening up, something that we see in senior loan officer survey results that show banks are making it more difficult for all sorts of borrowers to borrow. From consumers, to commercial borrowers, to commercial real estate borrowers, it's just much more strict, and so that typically feeds into companies’ investment spending. If it's difficult to get funding and we start to see things like a slowdown in Capex and that feeds right into GDP growth. The other element is that we think there's still some effect of the market adjusting to higher interest rates through debt rollovers. There are trillions of dollars, a little over $1 trillion in debt across investment grade and high yield coming due in the corporate bond market between 2024 and 2025. Most people would say that's typical, but what's not typical is that it's coming due in an environment where rates are materially higher. And that's true even taking into account our views on rate cuts. Because of a recession, we see inflation softening, so that's good news. We see Fed easing, rates coming down, so that's good news and should support fixed income. But because we see elevated recession risks, we are worried about credit spreads, which right now mostly reflect the soft landing view, and you don't have a lot of cushion to the downside if you end up being wrong. So again, we're sort of cautiously optimistic there. I think there's pockets in credit where you could position to be more defensive and have less risk of exposure that credit spreads could widen, but nonetheless presents a risk ofspillovers for other investors.
And then I guess the last couple of things I'll say is we do see another challenging year for rating migration with more credit rating downgrades and upgrades. And we still think that we're going to be in a default cycle. The severity of which is going to be still unclear right now for a number of reasons. Private credit is transferring some of the risk from the syndicated or the followed market into private markets where there's not a lot of transparency. But I also think there's still a lot of uncertainty around where recovery rates are shaking out. They've been very low. It's really a place where you want to be avoiding defaults right now. Well, right now we're thinking that we get into a mild default cycle, in and around 5 to 7 percent default rate in high yield, which is just above the historical average.
Maria Giraldo: That is a great question. It's something we are always considering. It’s hard to forecast, but it's important to keep an eye on risks about being wrong. And right now, I think most of the risks we really see are to the downside, just challenges that remain, particularly among the small banks. We see consumer credit, even though at an aggregate level, consumer credit is in a good position. Consumers aren't as over levered as they have been in the past, and they do still have some savings buffers. But the credit is deteriorating, and credit card delinquencies are at a record level within the small banks that lend to consumers. So that's something that the banks are going to have to contend with and then at the same time, the state of commercial real estate market is deteriorating. The markets are going to be forced to realize, I think, next year where prices really are with more situations like WeWork and small banks have significant exposure to commercial real estate, and they also still have the pressure of net interest margins are getting squeezed. Cost of funding is very high amongst the small banks. They're having to really compete still with depositors just flowing through to other areas that pay a high a yield for those deposits. So really not generating quite as much of interest income as the banks have historically. So, I think something still might be ahead for the small banks. Some shake up in that space. It's hard to predict what the outcome of that is going to be because it all also depends on the Fed's reaction to that type of scenario. And on that note too, the Fed overtightening is another big risk. We just won't know if they end up over tightening until there's in shock. So that's a difficult one to predict, but it's one that could very easily usher in a more severe recession. And of course, always, global elements are at play here. Downside risks from China, downside risks from Japan's central bank, trying to tighten policy or normalize the balance sheet. War always presents more risks. There's a lot of downside risk to the view.
Jay Diamond: We've gone over so much, Maria. It’s always a pleasure to talk to you. But before I let you go, if you could sum up, what are the final takeaways you have for our listeners?
Maria Giraldo: As we look out to 2024, we think there are reasons to be optimistic about fixed income performance next year with the Fed shifting gears. And that's something that we haven't said over the past several years. And so, I think that is something for everyone to consider, regardless of your time horizon over which you're investing, your return profile, I think just an allocation to fixed income in an environment where yields are where they are definitely makes sense. And then as for credit, though, specifically, I do want to emphasize this cautiously optimistic approach. It's one in which we think next year the market's going to be in a good place to deliver strong returns. We think, over the next several years, especially as you look out the longer horizon, we think returns look attractive. But for the next year, you want to be more selective. You want to be more nuanced about how we think about risks and opportunities. And importantly, investors need to stay nimble next year because we're shifting into a different economic and a different monetary policy regime.
Jay Diamond: Well, thank you so much for your time and us from very illuminating. Hope your Thanksgiving week has been fun and enjoyable and please come again and visit with us soon.
Maria Giraldo: Likewise! Yes. Thanks, Jay. It's always great spending time with you on the podcast.
Jay Diamond: Well, my thanks once again to Maria Giraldo for joining us today. And thanks to all of you who have joined us for our podcast. If you like what you are hearing, please rate us five stars. And if you have any questions for Maria or any of our other podcast guests, please send them to firstname.lastname@example.org and we will do our best to answer them on a future episode or offline. I’m Jay Diamond, and we look forward to gathering again for the next episode of Macro Markets with Guggenheim Investments. In the meantime, for more of our thought leadership, please visit guggenheiminvestments.com/perspectives. So long.
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