Macro Perspective

The key to an improved tone and more stability in fixed-income markets is a moderation in inflation. Our base case is that the supply chains will slowly begin to normalize. This trend, combined with the Federal Reserve (Fed) and other major central banks around the world tightening monetary policy along with declining real incomes slowing consumption, should see inflation moderate. In the US, there are signs that the housing market is beginning to slow as higher mortgage rates begin to bite. Anecdotal evidence from corporates indicates inventories are normalizing and demand is softening. In Europe, higher energy costs and inflation are hampering consumption and negatively impacting business confidence. We anticipate inflationary pressures will peak in 3Q22 and decline into 2023. While global central banks are expected to raise interest rates further in the short term, we believe more aggressive action is already anticipated by the markets. Fundamental headwinds to global growth and inflation remain. These include the reduction of global fiscal stimulus, the withdrawal of monetary policy accommodation and the persistence of secular-related headwinds such as global debt burdens, aging demographics and technology displacement. As growth and inflation moderate and the risks surrounding central bank policy become more balanced, so too should the market environment for fixed-income investors. Not only may the rise in government yields abate, but lower volatility could also lead investors to reengage in fixed-income spread sectors, especially given current valuations.

Spotlight: Is Credit More Attractive Than Stocks?

In below-investment-grade corporate credit markets, yields have risen by over 4.5 percentage points in the first half of the year, leaving high-yield benchmarks near 9%. During this period of rising interest rates and increased uncertainty around inflation, asset price multiples have declined. For instance, in high-yield markets, enterprise value relative to EBITDA declined by 12% year to date (YTD) to 8.8x, which is slightly less than the decline in asset multiples for the S&P 500 to 12.8x. Issuer composition and weightings likely explain some of the differences, but the magnitude and direction of multiples investors pay on assets changed similarly despite still strong corporate fundamentals. For background, corporate fundamentals entered this period of uncertainty well prepared. On average over the four quarters ending in March 2022, EBIDTA grew more than 15% on average for high-yield companies, margins expanded as corporations raised prices to customers more than their input costs, and most measures of leverage declined on a year-over-year (YoY) basis as earnings and cashflow rose faster than debt, according to Morgan Stanley Research as of March 2022.

Exhibit 1: Asian IG Credit Versus US IG Credit Spreads
(Select the image to expand the view.)
Exhibit 1

At current yields, high-yield may offer equity-like returns with lower risk. While the potential outcomes will depend on many factors, let’s look at two possible scenarios for simplicity: (1) multiples remain stable and (2) equity multiples decline 24% (in-line with the 2009 and 2020 recessions). In the first scenario, where asset multiples don’t change, the equity returns would largely be from dividends, so closer to 1.7% based on the S&P 500 dividend yield as of 2Q22. As for high-yield, yields of approximately 9% at quarter-end would suggest a potential return that is similar if equity multiples don’t decline. This potential return assumes that Treasury yields and spreads don’t change, and it also assumes losses from defaults could be avoided. If equity multiples decline by 24%, applied equally to high-yield and the S&P 500, then stocks would likely have a total return of -22% assuming some income from dividends and high-yield may have a return very close to 0%. This scenario assumes no defaults and also no benefit from potentially declining government bonds.

Exhibit 2: High-Yield Outcomes Look Attractive vs. Equity
(Select the image to expand the view.)
Exhibit 2

While this analysis is simplistic, it’s meant to illustrate that equity returns should look less compelling as asset multiples are still elevated. In addition, if multiple expansion doesn’t provide additional return for equity, then dividend yields would need to increase in order to improve the outlook for returns. With regard to credit, yields near 9% should provide for historical equity-like returns, but with lower volatility. Furthermore, should correlations between government bond yields and stocks and spreads revert to their historical inverse relationship, then high-yield credit volatility would likely decline too. For more information, please refer to our recent blog post: Potential 2022 Recession and Why Credit Looks Attractive vs. Equity.

Global Credit Markets: Relative Value Round-Up

Active management in fixed-income is essential to identify and exploit value opportunities and to manage downside risk. Here, we present our Investment Team’s high-level views across global credit markets. In the Global Corporate Credit Sector Views section, we provide our Investment Team’s latest views by industry.

Investment-Grade (IG) Credit
Corporate fundamentals may be peaking, but they are coming off a strong starting point. Concerns abound that profit margins may contract given rising input costs but margins are still near decade highs, while cash balances are also still elevated on an historical basis. The banking sector is also in robust shape given the high level of cautious oversight from regulators. Recent re-pricing made valuations more appealing as corporate fundamentals remain strong. The portfolios continue to maintain overweights to banking (where we believe further ratings upgrades are still ahead), energy (still behaving conservatively), select reopening industries and rising-star candidates, where allowed. Fundamentals in European IG are strong but may deteriorate from here as a growth slowdown becomes more likely. Exposure to Russian gas is a current concern with particular focus on German industrial and utility credits. Bank balance sheets remain in strong shape with higher rates supportive of profitability. Yields have reached multi-year highs in euro-denominated IG, and IG spreads look attractive on both a historical and also a cross-currency-adjusted basis. With the European Central Bank (ECB) no longer buying in size and uncertainty around growth and inflation, we do not expect a reversion to the 2021 tights. We find most value in subordinated financials and REITs.

High Yield (HY) Credit
US HY spreads are attractive. A moderating nominal growth environment will likely align with a rising, but below-average default rate. Technicals have been negative YTD given outflows from mutual funds, but higher yields are beginning to attract new institutional buyers. We continue to position for a “reopening trade” and potential rising stars should volatility decline and growth slow only moderately. We remain overweight certain cyclical sectors including airlines, cruise lines and select lodging credits, complemented by a higher quality bias in less cyclical subsectors. In Europe, the fundamentals picture is challenged as headwinds continue to mount. ECB tightening monetary policy, energy supply concerns and inflation pressures impacting both growth sentiment and potentially corporate profitability. Refinancing needs for existing issuers are modest, given the prior year’s supply. Excluding the 2020 Covid shock, yields are back to levels not seen since 2012. Spreads have widened from 340 basis points (bps) at start of the year to 670 bps at end-June. We remain selective, focusing on more defensive, less cyclical sectors such as telecom/cable and pharma. We are cautious on chemicals and consumer cyclical borrowers.

Bank Loans and Collateralized Loan Obligations (CLOs)
Bank loan spreads are relatively attractive. While fundamentals are expected to decline from robust levels as growth slows, defaults are expected to remain below average. Valuations have improved meaningfully, and technicals may soon improve as demand for discounted floating-rate loans from CLOs and institutions exceeds the limited new-issue supply. We believe outperformance will come from credit selection and avoiding problem credits. In the CLO sector, any improvement in CLO arbitrage or reduction of broader macro volatility is likely to be met with elevated CLO issuance keeping spreads relatively range-bound in the near term. Hedging costs for overseas investors have risen so far on the year but high-quality CLOs still screen attractive for overseas investors, which should lead to demand. We view AAA CLO debt at current levels as very attractive and retain our view that it will continue to perform well in either bullish or bearish bank loan spread environments given strong structural protections. IG-rated mezzanine tranches at current spreads and dollar prices are attractive as this part of the capital structure remains well insulated from credit losses.

Municipals
Municipal fundamentals continued to benefit from record revenue collections associated with a tight labor market as well as national reopening trends. As the Fed raises rates to combat inflation and domestic growth moderates, Western Asset expects state and local revenue growth to slow. However, considering record reserve balances combined with pandemic support that can be allocated through 2026, we believe municipalities are in a strong position to manage through economic volatility. We maintain an overweight to higher-beta revenue sectors that would continue to benefit from an ongoing economic recovery, while also finding incremental value in large high-grade issuers with favorable liquidity characteristics.

Emerging Markets (EM)
The unevenness of pandemic recovery across regions and countries has led to a greater emphasis on idiosyncratic risks. We continue to believe IG- and crossover-rated EM sovereigns are attractive from a carry standpoint, while vigilance is warranted on lower-rated countries given the pandemic’s impact on sovereign credit quality. EM growth challenges, heightened geopolitical risks and Fed tightening are historically not supportive of EM FX. In addition, inflation concerns continue to be a dominant theme for central banks. The aggressive approach to monetary tightening over the past year does provide some counterbalance, reflected in the higher cost of carry across EM local markets. By region, Asia stands to benefit given a resumption of global trade activities, while the currencies of weaker countries remain vulnerable to market swings.

Mortgage and Consumer Credit
Diminishing Fed and bank demand for agency mortgage-backed securities (MBS) coupled with increased volatility remain headwinds for the sector, but the fundamental picture has greatly improved as spreads widened significantly YTD and prepayment risk subsided. We favor conventional MBS relative to Ginnie Mae as the current administration has made a noticeable shift to expand affordable housing. We are also constructive on 30- and 20-year subsectors relative to 15-year MBS. In the non-agency residential mortgage-backed space (NARMB), housing has performed strongly over the past year with national home prices increasing 20.4% YoY. While real estate prices are expected to cool from the record increases, market spreads are elevated with increased risk premiums. Due to the increase in new-issue supply, we are opportunistic on credit risk transfer (CRT) securities as well as non-QM deals. In the commercial space, fundamentals vary by sector with continued strength in multi-family, industrial and lodging, but challenges remain in retail and office. Higher coupons have stunted new transaction activity but the slowing pipeline is putting upward pressure on discounted bonds. As macro and supply pressures ease, we are constructive across the capital stack for high-quality credits. Finally, in the asset-backed securities (ABS) sector, while consumers are better positioned thanks to Covid relief, we are cautious on consumer fundamentals and watchful of credit deterioration due to the reduction of direct aid and the long-term structural challenges. We favor well-protected ABS classes from higher quality sectors. We’re neutral at the top of the capital stack and selective in IG-rated tranches.

Spotlight: Is Credit More Attractive Than Stocks?
Star Icon

Outcomes depend on many factors; here we examine two possible scenarios: multiples stabilizing, and equity multiples declining in line with 2009 and 2020 recessions.

In below-investment-grade corporate credit markets, yields have risen by over 4.5 percentage points in the first half of the year, leaving high-yield benchmarks near 9%. During this period of rising interest rates and increased uncertainty around inflation, asset price multiples have declined. For instance, in high-yield markets, enterprise value relative to EBITDA declined by 12% year to date (YTD) to 8.8x, which is slightly less than the decline in asset multiples for the S&P 500 to 12.8x. Issuer composition and weightings likely explain some of the differences, but the magnitude and direction of multiples investors pay on assets changed similarly despite still strong corporate fundamentals. For background, corporate fundamentals entered this period of uncertainty well prepared. On average over the four quarters ending in March 2022, EBIDTA grew more than 15% on average for high-yield companies, margins expanded as corporations raised prices to customers more than their input costs, and most measures of leverage declined on a year-over-year (YoY) basis as earnings and cashflow rose faster than debt, according to Morgan Stanley Research as of March 2022.

Exhibit 1: Are High-Yield Credit Multiples Less Vulnerable?

Exhibit 1: Are High-Yield Credit Multiples Less Vulnerable?

At current yields, high-yield may offer equity-like returns with lower risk. While the potential outcomes will depend on many factors, let’s look at two possible scenarios for simplicity: (1) multiples remain stable and (2) equity multiples decline 24% (in-line with the 2009 and 2020 recessions). In the first scenario, where asset multiples don’t change, the equity returns would largely be from dividends, so closer to 1.7% based on the S&P 500 dividend yield as of 2Q22. As for high-yield, yields of approximately 9% at quarter-end would suggest a potential return that is similar if equity multiples don’t decline. This potential return assumes that Treasury yields and spreads don’t change, and it also assumes losses from defaults could be avoided. If equity multiples decline by 24%, applied equally to high-yield and the S&P 500, then stocks would likely have a total return of -22% assuming some income from dividends and high-yield may have a return very close to 0%. This scenario assumes no defaults and also no benefit from potentially declining government bonds.

Exhibit 2: High-Yield Outcomes Look Attractive vs. Equity

Exhibit 2: High-Yield Outcomes Look Attractive vs. Equity

While this analysis is simplistic, it’s meant to illustrate that equity returns should look less compelling as asset multiples are still elevated. In addition, if multiple expansion doesn’t provide additional return for equity, then dividend yields would need to increase in order to improve the outlook for returns. With regard to credit, yields near 9% should provide for historical equity-like returns, but with lower volatility. Furthermore, should correlations between government bond yields and stocks and spreads revert to their historical inverse relationship, then high-yield credit volatility would likely decline too. For more information, please refer to our recent blog post: Potential 2022 Recession and Why Credit Looks Attractive vs. Equity.

Global Credit Markets: Relative Value Round-Up
Global Credit Markets Icon

Active management is essential to exploit opportunities and manage risks; amid moderating growth and across global credit markets, we see evidence of both.

Active management in fixed-income is essential to identify and exploit value opportunities and to manage downside risk. Here, we present our Investment Team’s high-level views across global credit markets. In the Global Corporate Credit Sector Views section, we provide our Investment Team’s latest views by industry.

Investment-Grade (IG) Credit
Corporate fundamentals may be peaking, but they are coming off a strong starting point. Concerns abound that profit margins may contract given rising input costs but margins are still near decade highs, while cash balances are also still elevated on an historical basis. The banking sector is also in robust shape given the high level of cautious oversight from regulators. Recent re-pricing made valuations more appealing as corporate fundamentals remain strong. The portfolios continue to maintain overweights to banking (where we believe further ratings upgrades are still ahead), energy (still behaving conservatively), select reopening industries and rising-star candidates, where allowed. Fundamentals in European IG are strong but may deteriorate from here as a growth slowdown becomes more likely. Exposure to Russian gas is a current concern with particular focus on German industrial and utility credits. Bank balance sheets remain in strong shape with higher rates supportive of profitability. Yields have reached multi-year highs in euro-denominated IG, and IG spreads look attractive on both a historical and also a cross-currency-adjusted basis. With the European Central Bank (ECB) no longer buying in size and uncertainty around growth and inflation, we do not expect a reversion to the 2021 tights. We find most value in subordinated financials and REITs.

High Yield (HY) Credit
US HY spreads are attractive. A moderating nominal growth environment will likely align with a rising, but below-average default rate. Technicals have been negative YTD given outflows from mutual funds, but higher yields are beginning to attract new institutional buyers. We continue to position for a “reopening trade” and potential rising stars should volatility decline and growth slow only moderately. We remain overweight certain cyclical sectors including airlines, cruise lines and select lodging credits, complemented by a higher quality bias in less cyclical subsectors. In Europe, the fundamentals picture is challenged as headwinds continue to mount. ECB tightening monetary policy, energy supply concerns and inflation pressures impacting both growth sentiment and potentially corporate profitability. Refinancing needs for existing issuers are modest, given the prior year’s supply. Excluding the 2020 Covid shock, yields are back to levels not seen since 2012. Spreads have widened from 340 basis points (bps) at start of the year to 670 bps at end-June. We remain selective, focusing on more defensive, less cyclical sectors such as telecom/cable and pharma. We are cautious on chemicals and consumer cyclical borrowers.

Bank Loans and Collateralized Loan Obligations (CLOs)
Bank loan spreads are relatively attractive. While fundamentals are expected to decline from robust levels as growth slows, defaults are expected to remain below average. Valuations have improved meaningfully, and technicals may soon improve as demand for discounted floating-rate loans from CLOs and institutions exceeds the limited new-issue supply. We believe outperformance will come from credit selection and avoiding problem credits. In the CLO sector, any improvement in CLO arbitrage or reduction of broader macro volatility is likely to be met with elevated CLO issuance keeping spreads relatively range-bound in the near term. Hedging costs for overseas investors have risen so far on the year but high-quality CLOs still screen attractive for overseas investors, which should lead to demand. We view AAA CLO debt at current levels as very attractive and retain our view that it will continue to perform well in either bullish or bearish bank loan spread environments given strong structural protections. IG-rated mezzanine tranches at current spreads and dollar prices are attractive as this part of the capital structure remains well insulated from credit losses.

The unevenness of the Covid recovery across regions and countries has led to a greater emphasis on idiosyncratic risks, including growth challenges, geopolitical risk and inflation.

Municipals
Municipal fundamentals continued to benefit from record revenue collections associated with a tight labor market as well as national reopening trends. As the Fed raises rates to combat inflation and domestic growth moderates, Western Asset expects state and local revenue growth to slow. However, considering record reserve balances combined with pandemic support that can be allocated through 2026, we believe municipalities are in a strong position to manage through economic volatility. We maintain an overweight to higher-beta revenue sectors that would continue to benefit from an ongoing economic recovery, while also finding incremental value in large high-grade issuers with favorable liquidity characteristics.

Emerging Markets (EM)
The unevenness of pandemic recovery across regions and countries has led to a greater emphasis on idiosyncratic risks. We continue to believe IG- and crossover-rated EM sovereigns are attractive from a carry standpoint, while vigilance is warranted on lower-rated countries given the pandemic’s impact on sovereign credit quality. EM growth challenges, heightened geopolitical risks and Fed tightening are historically not supportive of EM FX. In addition, inflation concerns continue to be a dominant theme for central banks. The aggressive approach to monetary tightening over the past year does provide some counterbalance, reflected in the higher cost of carry across EM local markets. By region, Asia stands to benefit given a resumption of global trade activities, while the currencies of weaker countries remain vulnerable to market swings.

Mortgage and Consumer Credit
Diminishing Fed and bank demand for agency mortgage-backed securities (MBS) coupled with increased volatility remain headwinds for the sector, but the fundamental picture has greatly improved as spreads widened significantly YTD and prepayment risk subsided. We favor conventional MBS relative to Ginnie Mae as the current administration has made a noticeable shift to expand affordable housing. We are also constructive on 30- and 20-year subsectors relative to 15-year MBS. In the non-agency residential mortgage-backed space (NARMB), housing has performed strongly over the past year with national home prices increasing 20.4% YoY. While real estate prices are expected to cool from the record increases, market spreads are elevated with increased risk premiums. Due to the increase in new-issue supply, we are opportunistic on credit risk transfer (CRT) securities as well as non-QM deals. In the commercial space, fundamentals vary by sector with continued strength in multi-family, industrial and lodging, but challenges remain in retail and office. Higher coupons have stunted new transaction activity but the slowing pipeline is putting upward pressure on discounted bonds. As macro and supply pressures ease, we are constructive across the capital stack for high-quality credits. Finally, in the asset-backed securities (ABS) sector, while consumers are better positioned thanks to Covid relief, we are cautious on consumer fundamentals and watchful of credit deterioration due to the reduction of direct aid and the long-term structural challenges. We favor well-protected ABS classes from higher quality sectors. We’re neutral at the top of the capital stack and selective in IG-rated tranches.

Global Corporate Credit Sector Views

Auto & Related
Key Observations The global automotive market has experienced ongoing challenges associated with the COVID-19 pandemic, higher raw material input costs, all-time record highs in used car prices, the high adoption rate of electric vehicles and the worldwide semiconductor shortage on the industry supply chain. As we look further out to fiscal-year 2022, we believe progress will be made in terms of sourcing chips, although we are closely monitoring the impact of rising input costs on margins, as higher costs may offset a portion of the price/mix strength the OEMs and suppliers have clawed back throughout the pandemic given lower dealer inventory levels and strong consumer demand.
Banks
Key Observations We currently favor a large overweight to the highest-quality banks based on the resilient performance of their de-risked business models throughout Covid and arguably the strongest balance sheets in decades. Global regulatory best practices and tight supervisory oversight over the last decade provide strong pillars to our thesis that banks have grown into a simpler, safer and stronger industry. Increasingly conservative stress tests since the GFC have shown that banks should remain resilient to extraordinary losses and banks should perform quite well even with a mild recession and/or slower economic growth. In addition, higher global interest rates are structurally supportive of bank profits, banks have very limited exposure to current supply chain disruptions and global developed market (DM) banks also have minimal direct exposure to geopolitical risks in Eastern Europe.
Energy
Key Observations Oil prices remain high albeit off the peaks as demand destruction has begun to show signs amid the present macroeconomic uncertainties and continued high energy prices. However, the presence of tighter inventories (crude and refined products), limited spare production capacity, measured OPEC+ supply response, and observed supply disruptions continues to keep a tenuous balance. Capital spending restraint remains a key corporate strategy, particularly with the US participants, as the industry recognizes the inherent uncertainty that economically and geopolitically prevails and wants (even needs) to preserve balance sheet flexibility and strong liquidity; budget increases have occurred to offset cost inflation rather than grow production. Both oil and gas price backwardation still prevail despite the volatility.
Food & Beverage
Key Observations Third quarter results for the food and beverage companies should benefit from the abatement of certain commodity input cost headwinds, although transportation and supply chain costs remain elevated. The low unemployment rate and rising wages also support a rise in food and beverage spending that is further enhanced by the share of wallet shifting to services and eating out. Most food and beverage companies have strong balance sheets and solid liquidity, but lower stock valuations may be a catalyst for share-holder -friendly activity going forward.
Gaming
Key Observations Higher levels of food and fuel price inflation are expected to negatively affect consumer discretionary spending trends, particularly in the low- to middle-income tiers, and raise concerns about margin sustainability for the domestic gaming operators in US regional markets and on the Las Vegas Strip. Due to rising costs and ongoing Covid fears, we believe consumers are likely to incorporate higher levels of frugality in their daily lives in 2H22 and into year-end 2023. Asia-based operators, particularly those in Macau, continue to struggle with prohibitive COVID-19 travel restrictions, as the government looks to maintain its zero-tolerance policy throughout mainland China.
Health Care
Key Observations We believe supply will be less than the $93 billion issued in 2021 as the more muted M&A environment will continue to depress issuance potential. YTD, $40 billion of M&A has been announced vs. $71 billion last year. These impacts continue to be most pronounced in the medical device and distribution sectors. We believe margin pressures from higher transportation and input costs are manageable. In HY, we expect hospitals to report mixed earnings results the next couple of quarters as labor inflation remains a headwind and volumes remain weak. COVID-19 hospitalizations are also on the rise, doubling since May, driven by variant BA.5, which could also be disruptive to operations. We remain selective in this subsector.
Metals & Mining
Key Observations Metals markets have experienced a dramatic price decline in recent times that comes at the heels of continued geopolitical tension, China’s zero-Covid policy and subsequent lockdowns, concerns over recession and a stronger dollar. Short-term uncertainties still do not address the medium- to longer-term outlook and may only exacerbate the current supply side issues, particularly when future demand is supported by global energy transition endeavors. This may serve to tighten future balances and support higher prices which would lead to stronger earnings and cash flows. The industry is much better positioned in this current downcycle given managements’ prior focus on building stronger balance sheets and liquidity.
Pharmaceuticals
Key Observations In pharma, key market players have not seen major disruptions from COVID-19 and earnings results have generally come in line with expectations. We see a more stable generic pricing environment going into 2022, as supply/demand remains reasonable and delays for FDA generic approvals over the past year have been a key offset to standard generic price erosion. The near-term focus for HY pharma will be more idiosyncratic events specific to these credits (i.e., opioid litigation trials, patent challenges, spin-off transactions, etc.).
Retailing
Key Observations Elevated inflation has started to put immense pressure on consumers, which, in turn, risks a meaningful deterioration in broader retail sector fundamentals. In the US, ahead of Q2 earnings season, multiple retailers have already issued profit warnings citing weaker sales and inventory management challenges. The picture in Europe is bleak also. We highlight softness in discretionary spending on items such as large home appliances, homeware and DIY merchandise. Discount retailers, however, may not benefit since lower income consumer cohorts’ spending power is disproportionately negatively affected by ongoing inflationary pressures. The only subsector in which issuers so far appear relatively unaffected is luxury.
Telecommunications & Media
Key Observations Overall, we view the telecoms sector as a safe haven that should continue to outperform other industrial sectors in the event that macro risks manifest themselves more prominently. In the media space, ad spend has strongly rebounded as the global economy emerged from Covid. More recently, however, Chinese Covid-related restrictions and growing global recessionary risks have led forecasters to meaningfully downgrade their growth expectations around ad spend. We believe that this outlook reversal warrants fresh sensitivity around advertising-funded/-linked businesses.
Transportation
Key Observations During the Q2, leisure travel demand in the US has consistently exceeded 2019 levels due to pent-up demand, while domestic business travel has recovered to 80% of 2019 levels in the US. Demand is expected to remain robust in Q3, which is providing the airlines with decent pricing power, especially given their capacity discipline. However, airports and airlines are being stretched to their operational limits this summer as a result of labor shortages that has caused numerous flight cancellations across the major European hub cities. Going forward, the question is how a potential recession and inflation will impact demand, but the airlines have plenty of financial flexibility thanks to their cash hoards.
Utilities
Key Observations The US electric utility industry continues to focus its efforts on the regulated model with a bias to transmission assets over generation assets. Managements also deemphasize generation and non-traditional businesses with the aim to monetize. Capital investments continue to increase and are already estimated to remain elevated through at least 2024 with climate change agendas the focus. Consequently, leverage metrics continue to be tested to rating agency thresholds. This raises the potential for increased regulatory and political ire as customers will bear the brunt of the increase in capital budgets and financing costs now that interest rates have increased.
Industry Key Observations
Auto & Related The global automotive market has experienced ongoing challenges associated with the COVID-19 pandemic, higher raw material input costs, all-time record highs in used car prices, the high adoption rate of electric vehicles and the worldwide semiconductor shortage on the industry supply chain. As we look further out to fiscal-year 2022, we believe progress will be made in terms of sourcing chips, although we are closely monitoring the impact of rising input costs on margins, as higher costs may offset a portion of the price/mix strength the OEMs and suppliers have clawed back throughout the pandemic given lower dealer inventory levels and strong consumer demand.
Banks We currently favor a large overweight to the highest-quality banks based on the resilient performance of their de-risked business models throughout Covid and arguably the strongest balance sheets in decades. Global regulatory best practices and tight supervisory oversight over the last decade provide strong pillars to our thesis that banks have grown into a simpler, safer and stronger industry. Increasingly conservative stress tests since the GFC have shown that banks should remain resilient to extraordinary losses and banks should perform quite well even with a mild recession and/or slower economic growth. In addition, higher global interest rates are structurally supportive of bank profits, banks have very limited exposure to current supply chain disruptions and global developed market (DM) banks also have minimal direct exposure to geopolitical risks in Eastern Europe.
Energy Oil prices remain high albeit off the peaks as demand destruction has begun to show signs amid the present macroeconomic uncertainties and continued high energy prices. However, the presence of tighter inventories (crude and refined products), limited spare production capacity, measured OPEC+ supply response, and observed supply disruptions continues to keep a tenuous balance. Capital spending restraint remains a key corporate strategy, particularly with the US participants, as the industry recognizes the inherent uncertainty that economically and geopolitically prevails and wants (even needs) to preserve balance sheet flexibility and strong liquidity; budget increases have occurred to offset cost inflation rather than grow production. Both oil and gas price backwardation still prevail despite the volatility.
Food & Beverage Third quarter results for the food and beverage companies should benefit from the abatement of certain commodity input cost headwinds, although transportation and supply chain costs remain elevated. The low unemployment rate and rising wages also support a rise in food and beverage spending that is further enhanced by the share of wallet shifting to services and eating out. Most food and beverage companies have strong balance sheets and solid liquidity, but lower stock valuations may be a catalyst for share-holder -friendly activity going forward.
Gaming Higher levels of food and fuel price inflation are expected to negatively affect consumer discretionary spending trends, particularly in the low- to middle-income tiers, and raise concerns about margin sustainability for the domestic gaming operators in US regional markets and on the Las Vegas Strip. Due to rising costs and ongoing Covid fears, we believe consumers are likely to incorporate higher levels of frugality in their daily lives in 2H22 and into year-end 2023. Asia-based operators, particularly those in Macau, continue to struggle with prohibitive COVID-19 travel restrictions, as the government looks to maintain its zero-tolerance policy throughout mainland China.
Health Care We believe supply will be less than the $93 billion issued in 2021 as the more muted M&A environment will continue to depress issuance potential. YTD, $40 billion of M&A has been announced vs. $71 billion last year. These impacts continue to be most pronounced in the medical device and distribution sectors. We believe margin pressures from higher transportation and input costs are manageable. In HY, we expect hospitals to report mixed earnings results the next couple of quarters as labor inflation remains a headwind and volumes remain weak. COVID-19 hospitalizations are also on the rise, doubling since May, driven by variant BA.5, which could also be disruptive to operations. We remain selective in this subsector.
Metals & Mining Metals markets have experienced a dramatic price decline in recent times that comes at the heels of continued geopolitical tension, China’s zero-Covid policy and subsequent lockdowns, concerns over recession and a stronger dollar. Short-term uncertainties still do not address the medium- to longer-term outlook and may only exacerbate the current supply side issues, particularly when future demand is supported by global energy transition endeavors. This may serve to tighten future balances and support higher prices which would lead to stronger earnings and cash flows. The industry is much better positioned in this current downcycle given managements’ prior focus on building stronger balance sheets and liquidity.
Pharmaceuticals In pharma, key market players have not seen major disruptions from COVID-19 and earnings results have generally come in line with expectations. We see a more stable generic pricing environment going into 2022, as supply/demand remains reasonable and delays for FDA generic approvals over the past year have been a key offset to standard generic price erosion. The near-term focus for HY pharma will be more idiosyncratic events specific to these credits (i.e., opioid litigation trials, patent challenges, spin-off transactions, etc.).
Retailing Elevated inflation has started to put immense pressure on consumers, which, in turn, risks a meaningful deterioration in broader retail sector fundamentals. In the US, ahead of Q2 earnings season, multiple retailers have already issued profit warnings citing weaker sales and inventory management challenges. The picture in Europe is bleak also. We highlight softness in discretionary spending on items such as large home appliances, homeware and DIY merchandise. Discount retailers, however, may not benefit since lower income consumer cohorts’ spending power is disproportionately negatively affected by ongoing inflationary pressures. The only subsector in which issuers so far appear relatively unaffected is luxury.
Telecommunications & Media Overall, we view the telecoms sector as a safe haven that should continue to outperform other industrial sectors in the event that macro risks manifest themselves more prominently. In the media space, ad spend has strongly rebounded as the global economy emerged from Covid. More recently, however, Chinese Covid-related restrictions and growing global recessionary risks have led forecasters to meaningfully downgrade their growth expectations around ad spend. We believe that this outlook reversal warrants fresh sensitivity around advertising-funded/-linked businesses.
Transportation During the Q2, leisure travel demand in the US has consistently exceeded 2019 levels due to pent-up demand, while domestic business travel has recovered to 80% of 2019 levels in the US. Demand is expected to remain robust in Q3, which is providing the airlines with decent pricing power, especially given their capacity discipline. However, airports and airlines are being stretched to their operational limits this summer as a result of labor shortages that has caused numerous flight cancellations across the major European hub cities. Going forward, the question is how a potential recession and inflation will impact demand, but the airlines have plenty of financial flexibility thanks to their cash hoards.
Utilities The US electric utility industry continues to focus its efforts on the regulated model with a bias to transmission assets over generation assets. Managements also deemphasize generation and non-traditional businesses with the aim to monetize. Capital investments continue to increase and are already estimated to remain elevated through at least 2024 with climate change agendas the focus. Consequently, leverage metrics continue to be tested to rating agency thresholds. This raises the potential for increased regulatory and political ire as customers will bear the brunt of the increase in capital budgets and financing costs now that interest rates have increased.