As the current economic cycle draws to a close, our buy-and-maintain team discuss opportunities and risks in credit markets.
Read this article to understand:
- The impact of rising interest rates on companies and industries
- Where inflation and interest rates are heading around the globe
- How the team manage buy-and-maintain portfolios in the current environment
The global economy has proven more robust than expected in 2023 following the supply-side shocks that have fuelled inflation and reduced disposable incomes since 2022. As detailed in our House View Q3 2023, although growth has slowed, none of the major economies have entered recession, while several indicators of activity – such as global purchasing managers’ indices – suggest growth accelerated in the first half as energy prices dropped, lowering headline inflation.1
We are currently in the “late-cycle” phase of the economic cycle, which could persist for a while longer should the global economy continue to defy expectations with its unexpected resilience. However, we believe major developed economies still look set for below-trend growth in the near term. Given the persistence in core inflation, albeit with some tentatively encouraging signs in the underlying data, we expect interest rates to remain higher for longer.
So far, investment-grade credit has been resilient to these headwinds and, we would argue, remains attractive on a relative-value basis. Yields of over five per cent look reasonable given healthy company profits and the fact defaults are relatively rare. Additionally, US dollar-denominated non-financial corporate issuance is currently near the highest levels of any non-COVID year on record (at approximately $450 billion as of June 30, 2023).2
To discuss what might happen next, we put the questions to Iain Forrester (IF), head of global buy-and-maintain credit; Siddhartha Bhattacharyya (SB), senior portfolio manager, global buy-and-maintain credit; and Matthew Raque (MR), portfolio manager, global buy-and-maintain credit.
Which sectors are holding up well to the macroeconomic uncertainty and which are underperforming?
SB: The travel and leisure sectors, which suffered heavily during the pandemic, are benefiting from pent-up demand, primarily in subsectors such as airports. As an example, Heathrow Airport expects total passenger numbers this year to reach 96 per cent of 2019 (pre-pandemic) levels. On a selective basis, we see opportunities in these sectors.
On the opposite side, retail – lower-quality retail in particular – has suffered as higher interest rates have affected household spending. However, bigger names in the sector, primarily based in the US, have been able to pass on higher costs to consumers and retain margins. Commercial real estate (CRE) is another sector that has underperformed.
We are nearing peak interest rates in most developed countries. How is this influencing your thinking?
MR: The US Federal Reserve raised interest rates again in July, taking the target range for the federal funds rate up by 25 basis points to 5.25-5.5 per cent. Significantly, it did not signal this would be the last increase in rates but that future decisions would be data dependent. More recently, robust US economic data points to fresh inflationary pressures. July’s industrial production grew by one per cent versus expectations of 0.3 per cent.3
So far, economies have handled rate increases well and we are at, or close to, the peak of interest rates. Aside from the issues that hit banks in March, we have not seen any widespread fallout from higher rates. We continue to watch banks to see how they absorb higher costs and are also waiting to see more details on whether consumer spending is affected.
SB: We have an overweight in financials, although our exposure is primarily in high-quality globally systemically important banks (GSIBs). Overall, interest-rate hikes have been positive for GSIBs’ net interest margins. As a result, our positions were fairly insulated to the mini-banking crisis.
We also have holdings in CRE debt – primarily in the UK and Europe. The sector has underperformed due to higher rates, impacting property values. Once again, our holdings are at the higher-quality end of the sector, but we are reviewing our exposures and engaging with companies to gain a better understanding of their outlook. On a long-term horizon, we still view this sector positively.
IF: We look for sustainable businesses with strong pricing power that can maintain margins and profits. That approach has benefited our portfolios despite the challenges posed by inflation. In the consumer goods sector, strong brands (where our main exposures are) have been able to pass on a significant proportion of rising costs to customers. An example is Unilever, which reported strong quarterly earnings in July, beating sales growth forecasts.4
So far, we have not seen a big spike in defaults. Are you surprised at how resilient businesses have been despite the fact interest rates have risen so fast?
MR: Interest-rate hikes have been on companies’ radar for a while, and central banks have been well regimented with their signalling, so the increases have not come as a shock. As such, businesses have been well prepared to deal with them. Pricing power has been solid and, as Iain mentioned, some larger brands have been able to push increased costs through to consumers without a backlash. This might be because wages have also been increasing. But we are starting to see consumers trade down to private/own-label brands wherever they can.
SB: Another important reason is leverage, which has come down significantly since the peak leveraged buyout days of 2005-06 and the ensuing global financial crisis. The balance sheets of high-quality corporates are more resilient today due to lower leverage and their build-up of cash reserves. That is a big reason we have not seen the same problems as in previous crises.
IF: There is a natural lag in the impact of higher rates feeding their way through into direct costs for businesses. The challenges will only surface when they need to refinance at higher costs in the future. A mitigating factor, however, is that many companies extended the duration of their debt profiles in recent years, tendering shorter-dated bonds and issuing longer-dated debt. So, for many high-quality businesses, the maturity wall is further down the track and less of an issue.
With utilities an important part of B&M portfolios, have recent problems at Thames Water put utility investments into question?
SB: The troubles at Thames Water are very specific to the company, although there are sector-wide issues too. We have not been positive on the company for a long time due to its high leverage. While part of the problem can be laid at the door of regulators, the reputational fallout has exacerbated the situation. Thames Water’s problems are not down to liquidity. The company is well capitalised and supported by its investors with a commitment of £750 million for this regulated period and a further £3 billion in the next regulated period – beginning in 2025.5
However, there has been a knock-on effect on other utilities – particularly water companies – which were downgraded. Our holdings are in higher-rated UK water companies; we have engaged with these companies over the last year on their environmental challenges and how they plan to manage them.
Parts of the emerging-market debt universe look fragile given high rates and macro uncertainty. How are you positioning for this?
MR: The impact of higher rates can be split between higher-rated and high-yield countries. Our focus is mainly on investment-grade countries and having exposure to high-quality, hard-currency emerging-market sovereign debt, with no local currency exposure.
Central banks in many countries we invest in have been quick to respond to inflation challenges and raised rates aggressively in the last two years. Right now, we are seeing a turn in the cycle, and some have started cutting rates as inflation has come down. Chile became the first major central bank in Latin America to cut rates at the end of July.
The higher-rated economies have performed well against the challenging macro backdrop, with some helped by higher commodity prices. Nevertheless, challenges remain, including rising living costs, as these economies are typically more sensitive to higher food prices. That has led to social unrest in some Latin American countries. We are watching developments on core inflation around the globe and given current heatwaves and fires, how that impacts food supplies (and prices).
Do you anticipate any problems in replacing maturing assets?
IF: Many buy-and-maintain portfolios are tailored specifically to meet clients’ payment obligations, which reduces the need to replace maturing assets. Where we do look to replace bonds, we will not necessarily wait for the bonds to mature to find a replacement.
SB: We use primary and secondary markets to add exposure and are seeing opportunities in the dollar and euro markets (the latter has been very attractive since the middle of last year). There have been good opportunities to fine-tune parts of our portfolios by selling sterling holdings and buying dollar- and euro-denominated issues.
We are seeing record temperatures, wildfires and other extreme weather events this summer. How do you assess issuers’ resilience to climate risks?
IF: Individual physical risks from climate change, such as wildfires, are among many factors we consider. We want to invest in sustainable businesses. Integrating environmental, social and governance (ESG) factors into fundamental decision making is a key starting point.
We look closely at the sector and countries in which the issuer operates and, where relevant, consider the relevant governments’ climate transition commitments and plans. When we have concerns about material risks, we engage with companies and have had positive outcomes so far. However, most of our bond holdings tend to be global corporate entities and specific, localised events will not necessarily be a material factor.
Since Russia’s invasion of Ukraine, investments in gas and coal seem to have outpaced those in renewables. What is your view on the longer-term implications of this?
IF: There is clearly a need for a just and secure transition away from oil and gas. However, many of these businesses are currently essential to the continued functioning of the global economy. But it should not be forgotten they are also well-placed to support the transition to a net-zero world because of their capabilities, infrastructure and expertise, which could be redirected for carbon capture and other energy transition strategies. Simultaneously, we need to support the growth of renewables and move to net zero as fast as possible – that is where the challenge lies.
Demand is set to rise, particularly in gas, in the short term. Ultimately, this is a challenge that must be addressed at the sovereign level – to get the right balance between energy security and need for transition. For our part, we are trying to strike the right balance in our portfolios. Within the oil-and-gas sector, our exposures are heavily weighted towards the leaders in terms of their focus and commitment to these issues and net zero.
