Global Credit Outlook: 2Q2024

Key takeaways

• 1Q2024 was characterized by a reassessment of the start “timing” and depth of the rate cutting cycle in the U.S., as ongoing economic resilience and sticky inflation underscored the Federal Reserve’s (Fed) patient stance. A similar desire for more “confidence” on inflation fighting progress was echoed by the European Central Bank (ECB), despite a more challenging growth-inflation mix in that region.
• 2Q2024 will be critical as corporate credit investors seek confirmation on inflation progress and the start of monetary policy normalization.
• Despite the “delayed” prospect of rate relief, liquid and private corporate credit has been resilient – a trend we expect to continue in 2Q2024. That said, dispersion has been on the rise (in the USD and EUR markets) as borrowers continue to navigate this “high-for-longer” cost of capital landscape. The tactical case to own floating rate exposures in liquid and private credit should also persist into 2Q2024, given the rates backdrop.
• Our base case remains for the first Fed rate cut to begin in 2H2024, with the risks skewed earlier within that timeframe. That said, and as we have noted previously, the timing of the start of rate cuts is not the primary consideration for corporate credit investors.
• Rather, these factors are critical for investor risk appetite to remain supportive, in our view: (1) a high likelihood that the current Fed Funds rate represents the peak for this cycle (i.e., no more rate hikes are expected), (2) the expectation that rate cuts will begin eventually in 2024, and (3) the reason for the eventual rate cuts will be sustained improvement in inflation, as opposed to a sharp growth downturn.

Macro: Recalibrating rate cut expectations

1Q2024 was characterized by a backdrop of resilience: solid economic growth, fading concerns related to a near-term recession (especially in the U.S.) and debt capital markets which became receptive to even the lowest rated borrowers after a lull in such activity in 2H2023.

This, coupled with upside surprises to inflation in January and February, caused the market to recalibrate its expectations for Fed rate cuts: both in terms of timing (later) and magnitude (shallower/fewer). Entering 2024, market pricing suggested meaningful odds for the first cut in March 2024, and implied more than six 25bp rate cuts for the year. By late-March, that had been reduced to just over three cuts beginning in July 2024 (Exhibit 1).

We have viewed the bar for monetary policy normalization as high, given economic resilience, persistently high price pressures in some inflation categories (such as services/wages) and the Fed’s public commentary which signaled a reluctance to cut rates prematurely, only to have to “re-start” a rate hiking cycle. Our base case has remained for the first Fed rate cut to begin in 2H2024, with the risks skewed earlier within that timeframe. That said, and as we have noted previously, the timing of the start of rate cuts is not the primary consideration for corporate credit investors.

Rather, these factors are most critical for investor risk appetite to remain supportive in 2Q2024, in our view: (1) a high likelihood that the current Fed Funds rate represents the peak for this cycle (i.e., no more rate hikes are expected), (2) the expectation that rate cuts will begin eventually in 2024, and (3) the reason for the eventual rate cuts will be sustained improvement in inflation, as opposed to a sharp growth downturn.

Inflation reacceleration is a key risk

Inflation data in early 2024 has come in above consensus forecasts and has, on a higher frequency basis, halted the progress in place for much of 2H2023 (Exhibit 2). When asked (during the March FOMC press conference) about the strength of inflation data in January 2024 – and, to a lesser extent, February 2024 – Fed Chair Powell warned against the risk of “dismissing data that you don’t like,” even if seasonal adjustments were largely behind the January strength. He said the Committee does not know “whether this is a bump in the road or something more,” but that strength in the economy and labor market, alongside progress on inflation over a longer-term trend, “give us the ability to approach this question carefully.” Chair Powell also mentioned that “given the inflation data from January and February, it suggests we were right to wait until we were more confident” before starting a rate cutting cycle.

The Fed’s March 2024 Summary of Economic Projections reflected median forecasts for stronger U.S. real GDP growth and higher core inflation in 2024 – but an unchanged projected policy rate for the same year. When asked whether the lack of a change in the median 2024 Federal Funds “dot” reflected an increased tolerance for higher inflation, Chair Powell stated that the Committee is “strongly committed to bringing inflation down to 2% over time…but we stress, over time.” As a result, progress on the inflation fight will be key to watch in 2Q2024, in our view.

While not our base case, we view a sustained reacceleration in U.S. inflation data as a key downside risk for asset valuations. Such an outcome would likely introduce significant uncertainty related to the forward path for monetary policy and may have the potential to un-anchor longer-term inflation expectations.

The spread vs. yield “tug-of-war”

Index-level spreads for the Bloomberg USD Investment Grade (IG) and High Yield (HY) Corporate indices moved meaningfully tighter during 1Q2024, closing the quarter at 90bps and 299bps, respectively. The tightening of index-level spreads was even more notable considering the heavy pace of new issue activity in markets (discussed later). While some market observers took note of the tight spread levels as a measure of a potentially distorted market, we continue to have a more nuanced view. As Exhibits 5 and 6 illustrate, a broader perspective of corporate credit relative value shows that all-in yields remain quite attractive on a historical basis, which has likely encouraged capital deployment in the corporate credit markets from yield-based buyers. Indeed, we see a case for spreads across many rating and regional cohorts to move slightly tighter in 2Q2024, as (in many cases) they remain wide to the mid-2021 local troughs.

To support such a scenario, the following factors are most critical, in our view: 1) a high likelihood that the current Fed Funds rate represents the peak for this cycle (i.e., no additional rate hikes are expected), 2) the expectation that rate cuts will begin eventually in 2024, and 3) the reason for the eventual rate cuts will be sustained improvement in inflation, as opposed to a sharp growth downturn.

Dispersion remains elevated

The index level metrics mentioned previously omit an important point, however: under the surface, dispersion is evident across corporate credit. Exhibits 7 and 8 illustrate this by showing a common measure of spread dispersion among the constituents of the iBoxx USD and EUR corporate credit indices. While dispersion among the IG-rated cohort has been range bound in the USD market and has been declining in the EUR market, dispersion among HY rated issuers remains very elevated. We can see this element of dispersion using another method, which looks at the distribution of bond level spreads in the Bloomberg USD HY Corporate Index. While the index level average spread of 299bps may seem optically tight by many measures, 50% of the index par value trades inside of 200bps.

Past commentary

• 1Q2024