Macro Perspective

Global growth continues to downshift, led by Europe, the UK and China. In the US, we anticipate growth will slow further, but still avoid a recession. On the inflation front, weaker demand for manufacturing and services across a number of countries and deflationary pressures in China are easing price pressures globally. These trends, coupled with the accumulating effects of monetary tightening by the major central banks, should further dampen global economic growth and inflation which, in turn, should lead to lower developed market (DM) government bond yields and a modestly weaker US dollar. This macro backdrop is supportive for emerging market (EM) countries, particularly those in Latin America, which we expect to outperform. Other spread sectors such as high-yield, bank loans and select areas of the mortgage-backed securities (MBS) space offer attractive yield, but we acknowledge their vulnerability to unanticipated shifts in central bank policy, macro-related sentiment and unanticipated geopolitical developments. Lingering concerns over a “higher-for-longer” rate environment—driven by factors such as stronger-than-expected growth in the US, increased US Treasury (UST) supply to cover a growing fiscal deficit and inflation remaining above respective central bank targets—may also lead to episodes of heightened market volatility.

Global Credit Spotlight

Cash Is Not Always King
Investor behavior recently has been pointing to significant interest in cash or cash-like investments, such as Treasury bills, CDs and money market accounts, each currently offering very attractive rates. Given the S&P 500 Index and Bloomberg US Aggregate Bond Index in 2022 were down 19.4% and 13.1%, respectively, such a bias toward cash products seems reasonable. Returns of nine major asset classes since 2000, however, show us that cash was actually the worst performer in eight calendar years (36% of the time), and the best performer in only two calendar years (9% of the time). This raises compelling questions about what investors ought to be considering regarding cash and cash-equivalent investments.

It is our view at Western Asset that independent of the magnitude or timing of monetary policy easing in 2024, there is real opportunity for bonds to provide attractive risk-adjusted returns. Consider the performance of bonds relative to cash over the past six Federal Reserve (Fed) rate-hike cycles—they generated substantially better returns than cash-equivalent investments if an investor stayed the course over a three-year period, beginning with the first-rate hike (Exhibit 1).

Exhibit 1: Cumulative Bond Returns Relative to Cash Beginning with the First Rate Hike
Exhibit 1:  Cumulative Bond Returns Relative to Cash Beginning with the First Rate Hike Source: Bloomberg. As of 30 Nov 23.

Bonds offer both the potential for upside returns, as well as critical diversification benefits (Exhibit 2). In fact, bonds can act as a meaningful source of returns relative to cash, and a material offset to equity risk.

For a more detailed discussion, including our thoughts on the classic 60/40 portfolio and reinvestment risk, please refer to our recent blog from Western Asset’s Bryan Zac, Cash Is Not Always King.

Exhibit 2: Performance During Recessions—Stocks, Bonds and Cash
Exhibit 2:  Performance During Recessions—Stocks, Bonds and Cash Source: Bloomberg, US Treasury, Western Asset. As of 31 Jul 20.

Global Credit Markets: Relative Value Round-Up

Investment-Grade (IG) Credit
In the US, balance sheets remain robust enough to weather the widely forecasted slower economic backdrop. While corporate management teams have largely behaved conservatively given uncertainty with the macro backdrop, we are cautious about the potential for bondholder-unfriendly M&A activity to rise. Spreads are already pricing in a soft landing and do not offer much cushion against negative surprises. When weighed against a positive technical backdrop, we prefer to stay closer to home at this time. In Europe, spreads are slightly tight to historical average levels. Healthy demand for fixed-income on the back of buoyant corporate fundamentals could potentially support these tighter levels, but we may find better entry points.

High-Yield (HY) Credit
In the US, high-yield credit spreads are fair to relatively attractive. Yields may offer attractive returns in excess of defaults, which are likely to remain near or below historical averages given the higher credit quality of the market on average. Technicals may remain supportive as higher yields have attracted institutional and retail buyers, while issuance has been moderate. We continue to see opportunity in service-related sectors that are still recovering from the Covid-led recession (i.e., reopening trades including airlines, cruise lines and lodging) and potential rising stars. We are more cautious on consumer products, retailers and home construction. In Europe, corporate fundamentals remain decent given recent earnings, although we do observe some weakness in cyclical sectors given the slow European growth environment. Spreads narrowed during 4Q23 to around 410 basis points (bps) through the five-year average, so the sector may be vulnerable to a correction. We continue to like select short-dated, yield-to-call opportunities and remain selective on the new-issue calendar with a BB/B focus.

Municipals
Despite strong year-end performance, nominal municipal yields and tax-exempt income opportunities remain near decade-high levels. Considering resilient credit quality supported by strong tax collections, we anticipate improved demand will support the municipal market as cash investors face potentially lower income levels with the Fed

projecting to lower its fed funds rate in 2024. We seek opportunities to extend duration across portfolios, mindful of volatility that can offer better entry points ahead of tax season. We prefer lower-rated investment-grade securities that we expect will benefit from the resilient credit profile of traditional state and local government securities, but remain cautious on certain high-yield sectors that could be challenged by restrictive economic conditions.

Mortgage and Consumer Credit
The recent drop in mortgage rates in conjunction with easing inflation and rising consumer confidence has begun to reduce the pressure on housing affordability in the US. In the near-term, home prices on a national level are expected to remain constrained as they move toward long-run average annual increases of 3% to 4%. Regionally, however, increasing variations in home price performance as well as inventory levels are likely to persist. While real estate is presented with various challenges due to broad economic uncertainty, we do not see a significant risk of defaults in the broad residential market. In the residential space, we are opportunistic on credit risk transfer (CRT) securities as well as non-QM deals that present attractive borrower profiles and higher credit qualities. In the commercial space, the year ended with risk-on demand and a reach for yield where senior bond spreads tightened by 30 bps or more and depressed credit prices increased materially. However, on a relative basis, spreads remain wide across the capital structure, even more so in mezzanine and subordinate bonds. Lower, new-origination coupons should induce moderately higher transaction activity and refinancings; however, office sentiment has not improved. Low leverage exposures on high-quality real estate with meaningful borrower equity present compelling opportunities to lend in both the conduit and single-asset/single-borrower (SASB) market. New origination screens particularly attractive on a yield versus credit risk basis; however, some high-quality seasoned credits may offer outsized total return opportunities.

Emerging Markets (EM)
We view the combination of Fed easing, stable commodity prices and reduced geopolitical noise as key drivers of EM returns. Sources of risk encompass a “higher-for-longer” rate scenario in the US, unanticipated regional flare-ups and market volatility associated with upcoming elections in both EM and DM economies. In the EM sovereign space, we believe frontier market sovereigns represent a compelling 2024 total return opportunity, given still-wide valuations and key idiosyncratic credit stories. Turning to EM local markets, EM central banks’ proactive tightening measures over the past two years have set up a more positive outlook for both rates and FX in 2024. Latin American central banks have begun to start cutting rates, although continued easing will be dependent on Fed policy. While FX will remain highly macro-driven, elevated EM local bond yields, particularly in Latin America, can benefit from continued disinflation and a US soft landing. Conversely, Asian local currency yields remain historically low relative to USTs. Finally, EM corporates continue to maintain strong balance sheets, but we are watching the liquidity of domestic-focused issuers given higher local rates and tightened global financial conditions, while cyclical industries have headwinds from slower growth in Europe and China. Given comparatively tight valuations relative to DM corporates, we are focused on EM primary issuance at a concession to secondary.

Global Credit Spotlight

Cash Is Not Always King
Investor behavior recently has been pointing to significant interest in cash or cash-like investments, such as Treasury bills, CDs and money market accounts, each currently offering very attractive rates. Given the S&P 500 Index and Bloomberg US Aggregate Bond Index in 2022 were down 19.4% and 13.1%, respectively, such a bias toward cash products seems reasonable. Returns of nine major asset classes since 2000, however, show us that cash was actually the worst performer in eight calendar years (36% of the time), and the best performer in only two calendar years (9% of the time). This raises compelling questions about what investors ought to be considering regarding cash and cash-equivalent investments.

It is our view at Western Asset that independent of the magnitude or timing of monetary policy easing in 2024, there is real opportunity for bonds to provide attractive risk-adjusted returns. Consider the performance of bonds relative to cash over the past six Federal Reserve (Fed) rate-hike cycles—they generated substantially better returns than cash-equivalent investments if an investor stayed the course over a three-year period, beginning with the first-rate hike (Exhibit 1).

Exhibit 1: Cumulative Bond Returns Relative to Cash Beginning with the First Rate Hike

Exhibit 1:  Cumulative Bond Returns Relative to Cash Beginning with the First Rate Hike
Source: Bloomberg. As of 30 Nov 23.

Bonds offer both the potential for upside returns, as well as critical diversification benefits (Exhibit 2). In fact, bonds can act as a meaningful source of returns relative to cash, and a material offset to equity risk.

For a more detailed discussion, including our thoughts on the classic 60/40 portfolio and reinvestment risk, please refer to our recent blog from Western Asset’s Bryan Zac, Cash Is Not Always King.

Exhibit 2: Performance During Recessions—Stocks, Bonds and Cash

Exhibit 2:  Performance During Recessions—Stocks, Bonds and Cash
Source: Bloomberg, US Treasury, Western Asset. As of 31 Jul 20.
Global Credit Markets: Relative Value Round-Up

Investment-Grade (IG) Credit
In the US, balance sheets remain robust enough to weather the widely forecasted slower economic backdrop. While corporate management teams have largely behaved conservatively given uncertainty with the macro backdrop, we are cautious about the potential for bondholder-unfriendly M&A activity to rise. Spreads are already pricing in a soft landing and do not offer much cushion against negative surprises. When weighed against a positive technical backdrop, we prefer to stay closer to home at this time. In Europe, spreads are slightly tight to historical average levels. Healthy demand for fixed-income on the back of buoyant corporate fundamentals could potentially support these tighter levels, but we may find better entry points.

High-Yield (HY) Credit
In the US, high-yield credit spreads are fair to relatively attractive. Yields may offer attractive returns in excess of defaults, which are likely to remain near or below historical averages given the higher credit quality of the market on average. Technicals may remain supportive as higher yields have attracted institutional and retail buyers, while issuance has been moderate. We continue to see opportunity in service-related sectors that are still recovering from the Covid-led recession (i.e., reopening trades including airlines, cruise lines and lodging) and potential rising stars. We are more cautious on consumer products, retailers and home construction. In Europe, corporate fundamentals remain decent given recent earnings, although we do observe some weakness in cyclical sectors given the slow European growth environment. Spreads narrowed during 4Q23 to around 410 basis points (bps) through the five-year average, so the sector may be vulnerable to a correction. We continue to like select short-dated, yield-to-call opportunities and remain selective on the new-issue calendar with a BB/B focus.

Municipals
Despite strong year-end performance, nominal municipal yields and tax-exempt income opportunities remain near decade-high levels. Considering resilient credit quality supported by strong tax collections, we anticipate improved demand will support the municipal market as cash investors face potentially lower income levels with the Fed

projecting to lower its fed funds rate in 2024. We seek opportunities to extend duration across portfolios, mindful of volatility that can offer better entry points ahead of tax season. We prefer lower-rated investment-grade securities that we expect will benefit from the resilient credit profile of traditional state and local government securities, but remain cautious on certain high-yield sectors that could be challenged by restrictive economic conditions.

Mortgage and Consumer Credit
The recent drop in mortgage rates in conjunction with easing inflation and rising consumer confidence has begun to reduce the pressure on housing affordability in the US. In the near-term, home prices on a national level are expected to remain constrained as they move toward long-run average annual increases of 3% to 4%. Regionally, however, increasing variations in home price performance as well as inventory levels are likely to persist. While real estate is presented with various challenges due to broad economic uncertainty, we do not see a significant risk of defaults in the broad residential market. In the residential space, we are opportunistic on credit risk transfer (CRT) securities as well as non-QM deals that present attractive borrower profiles and higher credit qualities. In the commercial space, the year ended with risk-on demand and a reach for yield where senior bond spreads tightened by 30 bps or more and depressed credit prices increased materially. However, on a relative basis, spreads remain wide across the capital structure, even more so in mezzanine and subordinate bonds. Lower, new-origination coupons should induce moderately higher transaction activity and refinancings; however, office sentiment has not improved. Low leverage exposures on high-quality real estate with meaningful borrower equity present compelling opportunities to lend in both the conduit and single-asset/single-borrower (SASB) market. New origination screens particularly attractive on a yield versus credit risk basis; however, some high-quality seasoned credits may offer outsized total return opportunities.

Emerging Markets (EM)
We view the combination of Fed easing, stable commodity prices and reduced geopolitical noise as key drivers of EM returns. Sources of risk encompass a “higher-for-longer” rate scenario in the US, unanticipated regional flare-ups and market volatility associated with upcoming elections in both EM and DM economies. In the EM sovereign space, we believe frontier market sovereigns represent a compelling 2024 total return opportunity, given still-wide valuations and key idiosyncratic credit stories. Turning to EM local markets, EM central banks’ proactive tightening measures over the past two years have set up a more positive outlook for both rates and FX in 2024. Latin American central banks have begun to start cutting rates, although continued easing will be dependent on Fed policy. While FX will remain highly macro-driven, elevated EM local bond yields, particularly in Latin America, can benefit from continued disinflation and a US soft landing. Conversely, Asian local currency yields remain historically low relative to USTs. Finally, EM corporates continue to maintain strong balance sheets, but we are watching the liquidity of domestic-focused issuers given higher local rates and tightened global financial conditions, while cyclical industries have headwinds from slower growth in Europe and China. Given comparatively tight valuations relative to DM corporates, we are focused on EM primary issuance at a concession to secondary.

Global Corporate Credit Sector Views

Auto & Related
Key Observations Based on our current assessment of the US market, we anticipate the FYE 2024 US light vehicle seasonally adjusted annual rate (SAAR) to come in at 15.5 million units, as production trends begin to improve on the back of an improving supply-chain set-up and inventory re-stocking efforts at the dealer level, which will be partially offset by weaker consumer demand associated with higher interest rates (and the corresponding increase in monthly payments), and uncertainties about the onset of a possible recession later this year. The Detroit 3 automakers (Ford, General Motors and Stellantis) continue to operate with sustainable capital structures and solid product lines that make them much more investable than before the downturn. The automotive sector also includes captive finance divisions, such as Ally Financial, Ford Motor Credit and General Motors Financial, whose solid asset-class performance and improving balance sheets have allowed for ratings upgrades. Our outlook remains calling for weakened terms in auto lending standards, particularly as it relates to subprime issuance in the space. With US industry sales in a challenged backdrop, Western Asset believes that the auto industry upside/downside is neutral at this time, and likely biased toward a more negative stance as a result of the UAW strike, macroeconomic uncertainties in the US, ongoing US/China tension and weak profitability in Europe.
Banks
Key Observations We continue to favor a large overweight to the highest-quality banks globally based on the resilient performance of their de-risked business models since the global financial crisis (GFC). Our constructive secular view is that the risk profile of banks is much lower now given a new, strict rulebook with heightened supervisory oversight, dramatically higher capital and liquidity requirements, extreme fines and improved risk management. In contrast to the strength of the highest-quality banks, several mid-sized US regional banks failed in 2023. We view these regional bank failures as idiosyncratic and continue to expect the biggest banks to benefit from a flight to quality. Our view is that banks are navigating this period of heightened geopolitical and economic uncertainty as well as concerns rising from banks’ commercial real estate exposures (and in particular to the US office sector) with the strongest fundamentals in decades. This constructive view is not shared by skeptical rating agencies and investors, as seen in quite bearish credit ratings, equity valuations and credit spreads. 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 should perform quite well even with a mild recession and/or slower economic growth. In addition, the higher global interest rate environment is structurally supportive of bank profits.
Energy
Key Observations We expect oil & gas to remain in the energy mix even though energy transition aspirations continue. Our view remains that investment in the energy sector is a “carry trade” over “total return,” with the latter possible given continued consolidation trends we have observed. We have seen some softness in oil demand with the rise of economic uncertainty, monetary tightening and the reduced prospect of recession all resulting in a soft-landing scenario. We also acknowledge that the global election cycle is in full swing with more than 60 countries (over half the world’s population) going to the polls and energy costs will remain a likely focus. On the supply side, OPEC+ supply cuts and continued yet elevated geopolitical risks buoy prices as major choke points are in focus. We expect continued domestic US shale production growth, albeit increasing by smaller increments. We are also watching the declining crude inventories and relatively low product stocks, which could serve to balance the market and support prices. The domestic industry continues to demonstrate capital budget discipline, focused upon maximizing excess free cash flow for the benefit of shareholders as the balance sheet and liquidity considerations have been satisfied with earlier debt reduction focus. Production growth objectives have subsided and been replaced with offsetting portfolio production declines in many circumstances. Production growth has been replaced with increased M&A, bolstered existing positions, expanded into contiguous acreage and continues to expand into new areas. We have observed that, even with M&A activity, corporate managements have been using more equity in transactions, respecting the cyclical nature of the business as well as that of the balance sheet and liquidity. As we previously discussed, volatility in prices are expected to continue as fossil fuels remain part of the energy mix.
Food & Beverage
Key Observations Despite elevated interest rates, consumer spending remains resilient thanks to a healthy labor market and easing inflation that’s providing consumers with greater purchasing power. Labor and logistics costs have risen modestly, so food & beverage companies are working closely with food retailers to offer targeted promotions to attract frugal consumers. Food and beverage manufacturers face pressure to cut prices notwithstanding elevated input and commodity prices. Consumers continue to be cost-conscious with a focus on value that has resulted in consumers trading down to more affordable private label options. Amid these challenges, the success of food companies hinges on their ability to adapt to shifting consumer preferences. Finally, M&A activity in the food & beverage sector is expected to continue in 2024, especially as interest rates are likely to decline over the next 12 months.
Gaming
Key Observations We expect to see continued strength over the intermediate/long-term in Macau and Singapore, and a more balanced growth profile in the US. With this in mind, however, valuations in the sector reflect a strong rebound in activity. We remain focused on the sustainability of above-average margins, particularly in US regional markets and in Las Vegas. As such, we favor neutral positioning in the gaming sector, with a preference for continued exposure to Macau, as the relative value opportunity in this part of the world provides more total return potential in the next six to 12 months.
Health Care
Key Observations Western Asset is continuing to underweight investment-grade health care companies due to the cyclical and secular decline in credit quality, rich valuations and negative event risks. We continue to prefer payors over providers as payors have more pricing power, or a more stable revenue stream. For high-yield, we continue to expect health care volumes to trend positively, with in line to slightly better than normal seasonality due to post-Covid pent-up demand and surgeon availability following summer vacations. We continue to see improving trends for contract labor utilization, nursing turnover and labor rates. High-yield hospitals with California exposure (Tenet Healthcare in particular) could see potential labor pressures across their California footprint with health care minimum wage legislation on the Governor’s desk and roughly 75,000 Kaiser Permanente workers hit the picket lines, which could drive higher rates for temporary labor. On the legislative front, Congress continues to push for legislation on health care transparency, pharmacy benefit manager (PBM) reforms, site-neutral payment reforms and other health care proposals.
Metals & Mining
Key Observations Yields provide decent carry and there are some total return opportunities, particularly as M&A begins to come to the forefront. Idiosyncratic situations also provide for opportunities. Macro considerations continue to dominate the space; soft landing rhetoric, potential for the Fed cutting interest rates, and pace and form of China’s recovery in focus. Global demand has weakened with factory orders contracting. China has begun restocking and order books appear to be building. We continue to watch the construction/property and utility/electrical demand. However, a pause is expected around Chinese New Year. Nonetheless, we continue to watch the future implementation of policies which drive commodity appetite and strength. The energy transition story continues and remains an underlying thesis to remain involved in the metals space. We remain focused on copper as concentrate markets continue to tighten and the supply outlook becoming tighter still with the continued downward revisions in production guidance by producers. However, we have not seen the full impact of the supply disruptions yet. Similar to past comments, capital investment (and capital allocation, in general) in the metals space has been muted with the focus remaining on balance sheet protection and liquidity preservation so managements are better able to “weather a downcycle.” The better placed balance sheets and material free cash flow generation has allowed management to redirect excess cash flows to shareholder returns. With limited growth prospects/capital conservatism we continue to observe consolidation and M&A within the space. We remain selective in participation and focused upon copper.
Pharmaceuticals
Key Observations In the investment-grade space, we continue to favor underweighting pharma given many headwinds. First, in the regulatory/legislative environment, the FTC’s settlement with Amgen suggests heightened regulatory scrutiny, especially in M&A. Second, the Inflation Reduction Act has seemed to introduce uncertainties in the sector. Although the complete effects of the act have yet to be observed, it’s evident that some of its provisions will pose immediate challenges to pharma companies, while others will be felt in the longer term. Third, the risk posed by patent cliffs can’t be understated. Big names such as Amgen, AbbVie, Pfizer, Merck and Bristol Meyers are on the list. The expiration of patents could erode their revenue streams, putting pressure on these companies to innovate or acquire to fill the impending revenue gaps. The near-term focus for high-yield pharma will be more idiosyncratic events specific to these credits (e.g., opioid litigation, patent challenges, spinoff transactions, etc.). We do see potential for some rising-star activity over the next couple of years. Away from the higher-quality segment, lower-rated specialty pharma remains challenged and we expect to see aggressive liability management transactions pursued in 2024.
Retailing
Key Observations Consumers appear to have exhausted their excess savings from the Covid era. But December retail sales data, released on January 17 came in at +0.6%, ahead of market consensus. Looking ahead, a lot of the most recent macro developments appear to bode well for the consumer/retail sector. Indeed, the prospect of significant Fed rate cuts is feeding into cheaper mortgages, and, in turn, can positively impact consumer confidence/spending power. Delving into the details, we note significant variance between different retail subsectors. Luxury, for example, looks to be a challenging space at the moment as evidenced by multiple profit warnings/negative earnings surprises in Europe during the first two weeks of January. Conversely, discount retailers continue to eke out what we view as fairly strong results. Finally, ongoing disruptions in Panama and at the Suez Canal are impacting freight rates and may lead to goods delivery delays. In summary, we expect that subsector and individual issuer selection will once again make an important difference to portfolio performance.
Telecommunications & Media
Key Observations The COVID-19 pandemic prompted a rapid increase in the demand for greater capacity and faster wireless/broadband speeds, which heighted the need for capital investment. Operators are now in various stages of their capital investment plans. In the US, the largest wireless/wireline carriers have moved past the point of peak capital investment that followed outsized spectrum spend in late 2020, and have now refocused their efforts on balance sheet repair with a commitment to reaching leverage targets in the next few years. Within US cable, while many of the leading providers are now in the midst of upgrading and building out their networks, we are seeing the leading providers remain extremely financially disciplined in their effort. Overall, in 2024 we expect fairly benign conditions and solid operating performance out of the leading operators, which we believe will help underpin the sectors stable credit metrics. In Europe, we expect that potential consolidation transactions in markets including the UK, Italy and Spain can further help underpin market repair and improve sector return on capital employed. In the US, as a result of high market penetration, in the coming year we expect Telco and cable providers will continue to pursue share in each other’s markets, with cable offering its highly attractive converged mobile bundles while wireless/wirelines continue to market their fixed wireless products (home broadband).
Transportation
Key Observations In 2023, airline capacity in North America recovered to 94% of 2019 levels and is expected to fully recover in 2024. However, airline capacity growth will be tempered by ongoing OEM issues and persistent operational turbulence, such as understaffed air traffic control, constrained airports and supply-chain bottlenecks. The undersupply of aircraft is having a positive financial impact on aircraft values that’s benefitting both the airlines and the aircraft lessors. Thanks to aggressive hiring and wage increases in 2023, the pilot shortage problem has finally abated. Looking ahead, the industry faces a rising number of macro-economic headwinds, but during Covid several airlines diversified their revenue bases to include more loyalty, cargo, corporate and MRO services, for which demand is relatively inelastic. Finally, thanks to strong operating results last year, some of the legacy carriers have reinstated their dividend policies and may pursue additional pro-shareholder initiatives this year.
Utilities
Key Observations Valuations remain slightly attractive and we have opportunistically cut the underweight exposure down (but remain underweight). Our investment preference remains in First Mortgage bonds of select issuers, with selective participation in Unsecured Operating Company and Holding Company bonds. Nonetheless, participation remains selective. The industry continues to generate material negative free cash flow while managements also push the envelope on the capital structure to (almost) downgrade thresholds as governed by the rating agencies. The negative free cash flow is caused by investing significant capital in achieving renewable targets in addition to other larger scale grid (transmission and distribution) investments due to the aging infrastructure within the US. Consequently, the industry credit metrics remain weak relative to history given the continued debt issuance and managements reluctance to issue equity (outside of the Dividend Reinvestment Plan and ATM equity issuance). These increased costs, including the increased finance costs are recoverable in rates allowable by the regulators, hence passed on to customers via increased rates (on customer bills). Consequently, the relationship utilities maintain with regulators is increasing in importance and we monitor for any changes or developments that could raise the regulators’ ire hence the ability of the utility to recover prudently incurred costs in rates. An offset we have observed in recent times is managements’ focus on portfolio optimization, whereby they are scaling back on non-regulated, non-electric utility businesses and utilizing the proceeds to: (1) fund part of the capital budget needs, (2) resize the balance sheet (including reducing the proportion of holding company debt in the capital structure), and (3) increase shareholder returns.
Industry Key Observations
Auto & Related Based on our current assessment of the US market, we anticipate the FYE 2024 US light vehicle seasonally adjusted annual rate (SAAR) to come in at 15.5 million units, as production trends begin to improve on the back of an improving supply-chain set-up and inventory re-stocking efforts at the dealer level, which will be partially offset by weaker consumer demand associated with higher interest rates (and the corresponding increase in monthly payments), and uncertainties about the onset of a possible recession later this year. The Detroit 3 automakers (Ford, General Motors and Stellantis) continue to operate with sustainable capital structures and solid product lines that make them much more investable than before the downturn. The automotive sector also includes captive finance divisions, such as Ally Financial, Ford Motor Credit and General Motors Financial, whose solid asset-class performance and improving balance sheets have allowed for ratings upgrades. Our outlook remains calling for weakened terms in auto lending standards, particularly as it relates to subprime issuance in the space. With US industry sales in a challenged backdrop, Western Asset believes that the auto industry upside/downside is neutral at this time, and likely biased toward a more negative stance as a result of the UAW strike, macroeconomic uncertainties in the US, ongoing US/China tension and weak profitability in Europe.
Banks We continue to favor a large overweight to the highest-quality banks globally based on the resilient performance of their de-risked business models since the global financial crisis (GFC). Our constructive secular view is that the risk profile of banks is much lower now given a new, strict rulebook with heightened supervisory oversight, dramatically higher capital and liquidity requirements, extreme fines and improved risk management. In contrast to the strength of the highest-quality banks, several mid-sized US regional banks failed in 2023. We view these regional bank failures as idiosyncratic and continue to expect the biggest banks to benefit from a flight to quality. Our view is that banks are navigating this period of heightened geopolitical and economic uncertainty as well as concerns rising from banks’ commercial real estate exposures (and in particular to the US office sector) with the strongest fundamentals in decades. This constructive view is not shared by skeptical rating agencies and investors, as seen in quite bearish credit ratings, equity valuations and credit spreads. 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 should perform quite well even with a mild recession and/or slower economic growth. In addition, the higher global interest rate environment is structurally supportive of bank profits.
Energy We expect oil & gas to remain in the energy mix even though energy transition aspirations continue. Our view remains that investment in the energy sector is a “carry trade” over “total return,” with the latter possible given continued consolidation trends we have observed. We have seen some softness in oil demand with the rise of economic uncertainty, monetary tightening and the reduced prospect of recession all resulting in a soft-landing scenario. We also acknowledge that the global election cycle is in full swing with more than 60 countries (over half the world’s population) going to the polls and energy costs will remain a likely focus. On the supply side, OPEC+ supply cuts and continued yet elevated geopolitical risks buoy prices as major choke points are in focus. We expect continued domestic US shale production growth, albeit increasing by smaller increments. We are also watching the declining crude inventories and relatively low product stocks, which could serve to balance the market and support prices. The domestic industry continues to demonstrate capital budget discipline, focused upon maximizing excess free cash flow for the benefit of shareholders as the balance sheet and liquidity considerations have been satisfied with earlier debt reduction focus. Production growth objectives have subsided and been replaced with offsetting portfolio production declines in many circumstances. Production growth has been replaced with increased M&A, bolstered existing positions, expanded into contiguous acreage and continues to expand into new areas. We have observed that, even with M&A activity, corporate managements have been using more equity in transactions, respecting the cyclical nature of the business as well as that of the balance sheet and liquidity. As we previously discussed, volatility in prices are expected to continue as fossil fuels remain part of the energy mix.
Food & Beverage Despite elevated interest rates, consumer spending remains resilient thanks to a healthy labor market and easing inflation that’s providing consumers with greater purchasing power. Labor and logistics costs have risen modestly, so food & beverage companies are working closely with food retailers to offer targeted promotions to attract frugal consumers. Food and beverage manufacturers face pressure to cut prices notwithstanding elevated input and commodity prices. Consumers continue to be cost-conscious with a focus on value that has resulted in consumers trading down to more affordable private label options. Amid these challenges, the success of food companies hinges on their ability to adapt to shifting consumer preferences. Finally, M&A activity in the food & beverage sector is expected to continue in 2024, especially as interest rates are likely to decline over the next 12 months.
Gaming We expect to see continued strength over the intermediate/long-term in Macau and Singapore, and a more balanced growth profile in the US. With this in mind, however, valuations in the sector reflect a strong rebound in activity. We remain focused on the sustainability of above-average margins, particularly in US regional markets and in Las Vegas. As such, we favor neutral positioning in the gaming sector, with a preference for continued exposure to Macau, as the relative value opportunity in this part of the world provides more total return potential in the next six to 12 months.
Health Care Western Asset is continuing to underweight investment-grade health care companies due to the cyclical and secular decline in credit quality, rich valuations and negative event risks. We continue to prefer payors over providers as payors have more pricing power, or a more stable revenue stream. For high-yield, we continue to expect health care volumes to trend positively, with in line to slightly better than normal seasonality due to post-Covid pent-up demand and surgeon availability following summer vacations. We continue to see improving trends for contract labor utilization, nursing turnover and labor rates. High-yield hospitals with California exposure (Tenet Healthcare in particular) could see potential labor pressures across their California footprint with health care minimum wage legislation on the Governor’s desk and roughly 75,000 Kaiser Permanente workers hit the picket lines, which could drive higher rates for temporary labor. On the legislative front, Congress continues to push for legislation on health care transparency, pharmacy benefit manager (PBM) reforms, site-neutral payment reforms and other health care proposals.
Metals & Mining Yields provide decent carry and there are some total return opportunities, particularly as M&A begins to come to the forefront. Idiosyncratic situations also provide for opportunities. Macro considerations continue to dominate the space; soft landing rhetoric, potential for the Fed cutting interest rates, and pace and form of China’s recovery in focus. Global demand has weakened with factory orders contracting. China has begun restocking and order books appear to be building. We continue to watch the construction/property and utility/electrical demand. However, a pause is expected around Chinese New Year. Nonetheless, we continue to watch the future implementation of policies which drive commodity appetite and strength. The energy transition story continues and remains an underlying thesis to remain involved in the metals space. We remain focused on copper as concentrate markets continue to tighten and the supply outlook becoming tighter still with the continued downward revisions in production guidance by producers. However, we have not seen the full impact of the supply disruptions yet. Similar to past comments, capital investment (and capital allocation, in general) in the metals space has been muted with the focus remaining on balance sheet protection and liquidity preservation so managements are better able to “weather a downcycle.” The better placed balance sheets and material free cash flow generation has allowed management to redirect excess cash flows to shareholder returns. With limited growth prospects/capital conservatism we continue to observe consolidation and M&A within the space. We remain selective in participation and focused upon copper.
Pharmaceuticals In the investment-grade space, we continue to favor underweighting pharma given many headwinds. First, in the regulatory/legislative environment, the FTC’s settlement with Amgen suggests heightened regulatory scrutiny, especially in M&A. Second, the Inflation Reduction Act has seemed to introduce uncertainties in the sector. Although the complete effects of the act have yet to be observed, it’s evident that some of its provisions will pose immediate challenges to pharma companies, while others will be felt in the longer term. Third, the risk posed by patent cliffs can’t be understated. Big names such as Amgen, AbbVie, Pfizer, Merck and Bristol Meyers are on the list. The expiration of patents could erode their revenue streams, putting pressure on these companies to innovate or acquire to fill the impending revenue gaps. The near-term focus for high-yield pharma will be more idiosyncratic events specific to these credits (e.g., opioid litigation, patent challenges, spinoff transactions, etc.). We do see potential for some rising-star activity over the next couple of years. Away from the higher-quality segment, lower-rated specialty pharma remains challenged and we expect to see aggressive liability management transactions pursued in 2024.
Retailing Consumers appear to have exhausted their excess savings from the Covid era. But December retail sales data, released on January 17 came in at +0.6%, ahead of market consensus. Looking ahead, a lot of the most recent macro developments appear to bode well for the consumer/retail sector. Indeed, the prospect of significant Fed rate cuts is feeding into cheaper mortgages, and, in turn, can positively impact consumer confidence/spending power. Delving into the details, we note significant variance between different retail subsectors. Luxury, for example, looks to be a challenging space at the moment as evidenced by multiple profit warnings/negative earnings surprises in Europe during the first two weeks of January. Conversely, discount retailers continue to eke out what we view as fairly strong results. Finally, ongoing disruptions in Panama and at the Suez Canal are impacting freight rates and may lead to goods delivery delays. In summary, we expect that subsector and individual issuer selection will once again make an important difference to portfolio performance.
Telecommunications & Media The COVID-19 pandemic prompted a rapid increase in the demand for greater capacity and faster wireless/broadband speeds, which heighted the need for capital investment. Operators are now in various stages of their capital investment plans. In the US, the largest wireless/wireline carriers have moved past the point of peak capital investment that followed outsized spectrum spend in late 2020, and have now refocused their efforts on balance sheet repair with a commitment to reaching leverage targets in the next few years. Within US cable, while many of the leading providers are now in the midst of upgrading and building out their networks, we are seeing the leading providers remain extremely financially disciplined in their effort. Overall, in 2024 we expect fairly benign conditions and solid operating performance out of the leading operators, which we believe will help underpin the sectors stable credit metrics. In Europe, we expect that potential consolidation transactions in markets including the UK, Italy and Spain can further help underpin market repair and improve sector return on capital employed. In the US, as a result of high market penetration, in the coming year we expect Telco and cable providers will continue to pursue share in each other’s markets, with cable offering its highly attractive converged mobile bundles while wireless/wirelines continue to market their fixed wireless products (home broadband).
Transportation In 2023, airline capacity in North America recovered to 94% of 2019 levels and is expected to fully recover in 2024. However, airline capacity growth will be tempered by ongoing OEM issues and persistent operational turbulence, such as understaffed air traffic control, constrained airports and supply-chain bottlenecks. The undersupply of aircraft is having a positive financial impact on aircraft values that’s benefitting both the airlines and the aircraft lessors. Thanks to aggressive hiring and wage increases in 2023, the pilot shortage problem has finally abated. Looking ahead, the industry faces a rising number of macro-economic headwinds, but during Covid several airlines diversified their revenue bases to include more loyalty, cargo, corporate and MRO services, for which demand is relatively inelastic. Finally, thanks to strong operating results last year, some of the legacy carriers have reinstated their dividend policies and may pursue additional pro-shareholder initiatives this year.
Utilities Valuations remain slightly attractive and we have opportunistically cut the underweight exposure down (but remain underweight). Our investment preference remains in First Mortgage bonds of select issuers, with selective participation in Unsecured Operating Company and Holding Company bonds. Nonetheless, participation remains selective. The industry continues to generate material negative free cash flow while managements also push the envelope on the capital structure to (almost) downgrade thresholds as governed by the rating agencies. The negative free cash flow is caused by investing significant capital in achieving renewable targets in addition to other larger scale grid (transmission and distribution) investments due to the aging infrastructure within the US. Consequently, the industry credit metrics remain weak relative to history given the continued debt issuance and managements reluctance to issue equity (outside of the Dividend Reinvestment Plan and ATM equity issuance). These increased costs, including the increased finance costs are recoverable in rates allowable by the regulators, hence passed on to customers via increased rates (on customer bills). Consequently, the relationship utilities maintain with regulators is increasing in importance and we monitor for any changes or developments that could raise the regulators’ ire hence the ability of the utility to recover prudently incurred costs in rates. An offset we have observed in recent times is managements’ focus on portfolio optimization, whereby they are scaling back on non-regulated, non-electric utility businesses and utilizing the proceeds to: (1) fund part of the capital budget needs, (2) resize the balance sheet (including reducing the proportion of holding company debt in the capital structure), and (3) increase shareholder returns.