Casting Credit: The risks facing US credit and equities in 2024
US market valuations have continued to rise. Equity price-to-earnings ratios are at two-year highs and credit spreads are back to where they were before the Federal Reserve (Fed) started raising interest rates. Not much is cheap. Should this be a concern? Well, there are risks to current valuations which need to be considered. However, performance is being driven by a strong economy, a lack of any evidence of significant credit problems and healthy balance sheets and corporate profitability. Earnings are expected to grow in 2024 as US GDP growth continues to defy previous expectations. Moreover, rates should come down at some point. If that’s driven falling inflation, then lower rates will be positive for stocks and bonds. For now, any setback in market levels is likely to be met by a ‘buy-on-dips’ response.
Solid state
There’s a reason credit has got more expensive relative to government bonds. Investors like it. They like it because corporate balance sheets are strong, interest coverage is manageable despite higher yields and companies have a lot of cash, so their net interest burden is lower than in previous cycles. In other words, perceived risk is low. In addition, there is yield and this means income is helping drive, and more important, in total returns.
What are the risks?
Spreads are back to where they were just before the pandemic after credit delivered strong returns in 2019. Borrowers have been conservative with their balance sheets since – there has been no leverage boom. Meanwhile, earnings growth has been strong. The fundamental story is still attractive, so what could go wrong for credit? I think we can rule out any further increases in interest rates in the US or Europe, so any underperformance would have to come from factors that could drive credit spreads wider.
Slower growth
One risk is that economic growth slows more than it has so far, exposing weak and indebted sectors. While economists will argue whether the level of interest rates and overall financial conditions are tight, relative to some concept of neutral, it is unarguable that rates went up a long way in 2022 and 2023. Borrowers on fixed rates will have been cushioned from the impact to some extent, but there are plenty of consumer, credit card and auto liabilities that operate with floating rates. Credit card delinquency rates in the US have been rising since 2021 according to the Fed. Delinquency rates of more than 30 days on auto loans are currently at their highest levels since 2010. If growth slows and, importantly, unemployment begins to increase, some of these credit issues could receive more attention. However, the banking sector is well capitalised and these low-end consumer credit issues are unlikely to become a systematic risk. What may be more of an issue, albeit a slow moving one, is that some of the fundamental metrics supporting credit markets could deteriorate a little. Debt issuance has been running hot already in 2024, which means average interest costs are rising. The average coupon on the US investment grade market has moved up from 3.65% to 4.25% since mid-2022, and from 1.5% to 2.3% in Europe. These are sizeable moves and will put pressure on interest coverage ratios. But not enough to change the core view on credit, particularly as there is little evidence of a marked slowdown in growth, especially in the US.
Credit events
There is always the chance of a credit event. Regional banks have been in the spotlight over the last year, largely because of their exposure to commercial real estate (CRE) and, particularly, the office building market. I discussed this with our real estate team and economists this week and we came to the conclusion that CRE is a problem, albeit one with limited scope. The impact on larger banks is negligible given the amount of provisioning set aside for credit issues. Still, another regional bank issue related to CRE could have a negative impact on investor sentiment and could force the Fed to re-introduce liquidity tools. A shock and a central bank response would likely mean wider spreads, at least for a while.
Risk-off
Evidence of slower growth, a Fed reluctant to ease, sticky service sector inflation, some more bad news on commercial real estate and the uncertainties around what will happen after the US Presidential election could all contribute to a negative shift in risk appetite. Credit is quite expensive in the US. Equities are expensive too. Using consensus earnings estimates for 2025, the S&P 500 is trading on a multiple of 19 times. This is just below the recent peak of 20 times in 2021 when multiples expanded during the post-pandemic recovery. Few would be surprised if the stock market went through a period of adjustment, especially as much of the total return performance has been driven by a mere handful of technology stocks over the last year.
But carry is strong
All of the above are risks but, for now, they are not material enough to reverse positive momentum in markets. There is no recession, rates will probably come down in the second half of the year and companies are doing very well. Europe is weaker but lower rates should help, and the forecasts from the UK’s Office for Budgetary Responsibility, presented alongside this week’s fiscal Budget, are more positive. Any setback in markets should potentially be seen as an opportunity to invest (buy on dips). Given where yields are, carry will remain an important driver of total return in credit markets.
Better macro, fewer rate cuts
There’s another quarter to go before the market is expecting rates to be cut in the US and Europe. We have time to assess how markets are likely to respond. If it is a gentle easing against a backdrop of positive global growth, then bond returns are likely to be close to current yield levels (mid-single digits) and equities can still deliver something close to expected earnings growth (low double digits). While some might clamour for more rapid rate cuts, the likelihood is that if that were to happen, the macro backdrop would be much worse and thus, much worse for credit and equities. A Fed having to ease in and around a contentious Presidential election campaign would not be a favourable investment climate. The rest of the year is going to be interesting, but for now, stay with credit.
(Performance data/data sources: Refinitiv DataStream, Bloomberg, as of 6 March 2024, unless otherwise stated). Past performance should not be seen as a guide to future returns.
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Chris Iggo is the Chief Investment Officer for Core Investments and Chair of the AXA IM Investment Institute. In his role, Chris brings together the insights of the Research, Quant Lab and Responsible Investment teams for the benefit of all portfolio managers across asset classes.
Previously he was the CIO for AXA IM’s fixed income department, as well as Head of Active Fixed Income in Europe and Asia. In this role, Chris oversaw the investment process globally and was responsible for the management of all active teams in Europe and Asia, including the performance and strategy / fund development.
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This document is for informational purposes only and does not constitute investment research or financial analysis relating to transactions in financial instruments as per MIF Directive (2014/65/EU), nor does it constitute on the part of AXA Investment Managers or its affiliated companies an offer to buy or sell any investments, products or services, and should not be considered as solicitation or investment, legal or tax advice, a recommendation for an investment strategy or a personalized recommendation to buy or sell securities. It has been established on the basis of data, projections, forecasts, anticipations and hypothesis which are subjective. Its analysis and conclusions are the expression of an opinion, based on available data at a specific date. All information in this document is established on data made public by official providers of economic and market statistics. AXA Investment Managers disclaims any and all liability relating to a decision based on or for reliance on this document. All exhibits included in this document, unless stated otherwise, are as of the publication date of this document. Furthermore, due to the subjective nature of these opinions and analysis, these data, projections, forecasts, anticipations, hypothesis, etc. are not necessary used or followed by AXA IM’s portfolio management teams or its affiliates, who may act based on their own opinions. Any reproduction of this information, in whole or in part is, unless otherwise authorised by AXA IM, prohibited.
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Chris Iggo is the Chief Investment Officer for Core Investments and Chair of the AXA IM Investment Institute. In his role, Chris brings together the insights of the Research, Quant Lab and Responsible Investment teams for the benefit of all...
Expertise
Chris Iggo is the Chief Investment Officer for Core Investments and Chair of the AXA IM Investment Institute. In his role, Chris brings together the insights of the Research, Quant Lab and Responsible Investment teams for the benefit of all...
Expertise
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