Macro Perspective

The investment landscape faces enormous uncertainty following Russia’s invasion of Ukraine. The long slog to a post-Covid world has been meaningfully derailed. Energy and soft commodity prices are likely to remain high. The case for developed market (DM) government bond yields is less clear given current elevated inflation readings but the traditional desire for such a global safe haven is likely to be powerful. Our view remains that the global economic recovery from the Covid pandemic will be underpinned by responsible central bank policy that recognizes the detrimental effect that elevated energy prices and the uncertain situation in Eastern Europe will have on global growth. We have seen a rapid re-pricing of monetary policy expectations. While tensions in Ukraine are pushing up short-term energy prices and inflation, the medium- to long-term impacts have yet to be determined. Western Asset’s view is that while data on inflation and labor markets will likely lead to accelerated tightening schedules across a number of key DM central banks, the 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. Here, we provide a summary of where we see value across global credit markets.

Spotlight: Putting the Income Back into Fixed-Income

High-Yield (HY) Credit
High-yield remains relatively attractive versus high-quality bonds, given a supportive nominal economic growth and low default outlook. Historically, high-yield spreads are negatively correlated to government bonds, but that relationship has broken down a little recently—similar to what happened in the mid part of the 2013 taper tantrum. Technicals have been negative year to date (YTD) given outflows from fixed-income as interest rates have risen, but yields on actively managed high-yield strategies have risen by 2% and yields near 7% are beginning to attract new buyers. From a fundamentals perspective, the market’s credit quality has continued to improve with much of the index rated BB and with declining CCC exposure compared to several years ago. We continue to position for a “reopening trade” and rising stars. 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, high-yield fundamentals have improved, but markets now pricing in ongoing elevated input pricing pressure, lingering supply-chain issues and gradual tightening of monetary policy by the European Central Bank (ECB). Supply has decreased dramatically, supporting the technical picture. Valuations are relatively attractive in the context of lower-yielding, more interest rate sensitive European asset classes. We favor the telecom and cable sectors and have turned more cautious on some consumer-related sectors given a deterioration in disposable income.

Bank Loans and Collateralized Loan Obligations (CLOs)
Bank loan fundamentals in the US remain attractive and minimal defaults are expected given the economic outlook. We believe outperformance will come from carry and avoiding problem credits. The floating rate nature of tranches and healthy underlying credit fundamentals remain a positive tailwind for the CLO market. Technicals will likely remain balanced between buyers and sellers given valuations across competing sectors and lighter supply thus far in the year. Any improvement in the CLO arbitrage from somewhat elevated levels or a reduction of broader macro volatility is likely to be met with elevated CLO issuance, keeping spreads relatively range-bound in the near term. We view AAA CLO debt at current levels as very attractive and retain our view that AAA CLO debt will continue to perform well in either bullish or bearish bank loan spread environments given strong structural protections. Investment-grade rated mezzanine tranches at current spread and dollar prices are attractive, as this part of the capital structure remains well insulated from credit loss given the fundamental credit backdrop. Elevated supply should lead to opportunities to add below-investment-grade rated CLO debt, too.

Turning to European bank loans, we are positive on this segment of the market. Although the knock-on effects of the Ukraine conflict on commodity prices and supply chains across the continent cannot be ignored, reopening sectors and general fundamentals are still providing issuers with a strong operating tailwind. As a result, defaults are expected to remain at historically low levels this year. We do acknowledge that a more defensive sector allocation might become our preferred approach toward year-end if downside risks persist, but so far, financial reporting from loan issuers has remained strong. Returns for European loans thus far in 2022 have been resilient and have clearly outperformed other European risk assets, emphasizing solid fundamentals. CLOs have sailed through volatility and continued to issue at a decent pace, adjusting at times to widening spreads with structural adjustments, but overall benefiting from a functional market. As we’ve seen in the past, the expected rate hikes by the Fed and resulting increased costs of hedging USD-denominated CLO AAAs for Japanese investors might incur a reallocation toward euros, which might drive further demand for European CLOs and therefore bring additional inflows to bank loans in the region.

With regard to CLO equity, it may be one of the few investment choices that could provide generous income in excess of inflation. CLO equity can provide investors who have a buy-and-hold mentality with an attractive and relatively stable source of income. Since 2014, CLO equity averaged 4.4% in quarterly distributions—providing an annual income well above the rate of inflation, potentially in the mid-teens after fees and expenses, according to J.P. Morgan and Intex as of December 31, 2021. Within investors’ asset allocations, CLO equity can provide an increase in returns, reduce the J-curve of other private equity strategies and offer diversification benefits. The return and volatility profile for a 5% allocation to CLO equity can potentially enhance an investor’s return with limited to no increase in volatility when the sources of funds come from equity and alternative strategies. For those investors reducing fixed-income allocations, keeping in mind that CLO equity historically has been negatively correlated with US Treasuries, the impact on asset allocation strategies will likely increase returns but also volatility. As investors are seeking income, especially enough to offset the impact of higher inflation, an investment in CLO equity managed by an active manager could be a reasonable solution.

Municipals: Positive Credit Trends Contrast Negative Returns YTD
Municipal fundamentals have continued to exhibit strength during budget season, contrasting the record negative YTD returns. According to census data, state and local revenue collections hit a record high $1.9 trillion at 2021 calendar year-end, 15% higher than 2020 record-setting levels. Strong tax growth was driven by increases in Corporate Income Tax Receipts (+58%), Individual Income Tax Receipts (+22%), Sales Tax Receipts (+16%) and Property Tax Receipts (+5%).

Meanwhile, state and local payrolls remain below pre-pandemic levels. As the US labor market continues to demonstrate strength with an additional 1.7 million of nonfarm payrolls added YTD through March, state and local payrolls increased just 24,000 YTD and total state and local payrolls remain 4% below pre-pandemic levels. When paired with record revenue collections, budgetary prudence has contributed to robust growth in state reserves over the prior fiscal year. Elevated cash reserves, along with federal stimulus funds that have yet to be fully distributed and can be allocated through 2026, should ameliorate inflation-driven cost pressures and support a continued trend of upgrades that outpace downgrades over the medium-term. While constructive on credit conditions for the vast majority of the investment-grade municipal market, we are more cautious on select high-yield names, particularly in the project finance and Continuing Care Retirement Community (CCRC) sectors that have limited flexibility to manage through negative economic headwinds.

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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 across industries.

Investment-Grade (IG) Credit
We remain cautiously optimistic about corporate fundamentals near-term given the strong starting position while overall domestic economic growth should still be supportive despite additional headwinds emanating from the Russia-Ukraine conflict. We remain vigilant of potential shareholder-friendly activity (e.g., share buy-backs, M&A, etc.) but outside of a few examples of bondholder-unfriendly behavior, we have continued to witness conservative balance sheet management. Valuations temporarily repriced into attractive territory; however, overall spreads quickly retraced in the second half of March to levels that can be described as fair given the increased degree of uncertainty remaining. We continue to maintain overweights to banking, select reopening industries and rising-star candidates where allowed. In Europe, M&A/LBOs/a stretched consumer/supply chains are all key risks we are focused on. Bank balance sheets remain in strong shape with higher rates supportive of profitability. Yields have reached multi-year highs in euro IG bringing a surge in demand for high-quality bonds from insurance companies. We expect IG spreads to perform, but do not expect a reversion to the 2021 tights. We find most value in subordinated financials and REITs.

Emerging Markets (EM)
The unevenness of the post-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 could be vulnerable to market swings. Finally, EM primary issuance, priced at a concession to secondary and DM levels, currently offers attractive relative value; we continue to watch for more dislocated pockets of value in HY-rated corporate issuers.

Mortgage and Consumer Credit
Mortgage credit and asset-backed securities (ABS) spreads have widened and remain at wider levels relative to pre-Covid, and currently are at their widest level over the past year in spite of the overall strength of the US economy due to the remaining uncertainties and unevenness of the recovery. Consumer fundamentals have also improved post-Covid with increased savings rates, declining revolving consumer credit balances, and lower interest rates, which together have decreased debt burden levels to the lowest in 20 years. We see attractive opportunities in consumer ABS sectors focused on the prime quality borrowers. After a challenged year for commercial real estate with revenues limited due to mandated stay-at-home orders, the reopening of retailers and leisure travel has provided a tailwind for the industry. The team believes mortgage credit offers value backed by real assets that benefit from a rising inflation environment and can generate attractive risk-adjusted returns.

Spotlight: Putting the Income Back into Fixed-Income
Star Icon

A constructive view on CLOs, high-yield and bank loans.

High-Yield (HY) Credit
High-yield remains relatively attractive versus high-quality bonds, given a supportive nominal economic growth and low default outlook. Historically, high-yield spreads are negatively correlated to government bonds, but that relationship has broken down a little recently—similar to what happened in the mid part of the 2013 taper tantrum. Technicals have been negative year to date (YTD) given outflows from fixed-income as interest rates have risen, but yields on actively managed high-yield strategies have risen by 2% and yields near 7% are beginning to attract new buyers. From a fundamentals perspective, the market’s credit quality has continued to improve with much of the index rated BB and with declining CCC exposure compared to several years ago. We continue to position for a “reopening trade” and rising stars. 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, high-yield fundamentals have improved, but markets now pricing in ongoing elevated input pricing pressure, lingering supply-chain issues and gradual tightening of monetary policy by the European Central Bank (ECB). Supply has decreased dramatically, supporting the technical picture. Valuations are relatively attractive in the context of lower-yielding, more interest rate sensitive European asset classes. We favor the telecom and cable sectors and have turned more cautious on some consumer-related sectors given a deterioration in disposable income.

Bank Loans and Collateralized Loan Obligations (CLOs)
Bank loan fundamentals in the US remain attractive and minimal defaults are expected given the economic outlook. We believe outperformance will come from carry and avoiding problem credits. The floating rate nature of tranches and healthy underlying credit fundamentals remain a positive tailwind for the CLO market. Technicals will likely remain balanced between buyers and sellers given valuations across competing sectors and lighter supply thus far in the year. Any improvement in the CLO arbitrage from somewhat elevated levels or a reduction of broader macro volatility is likely to be met with elevated CLO issuance, keeping spreads relatively range-bound in the near term. We view AAA CLO debt at current levels as very attractive and retain our view that AAA CLO debt will continue to perform well in either bullish or bearish bank loan spread environments given strong structural protections. Investment-grade rated mezzanine tranches at current spread and dollar prices are attractive, as this part of the capital structure remains well insulated from credit loss given the fundamental credit backdrop. Elevated supply should lead to opportunities to add below-investment-grade rated CLO debt, too.

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Turning to European bank loans, we are positive on this segment of the market. Although the knock-on effects of the Ukraine conflict on commodity prices and supply chains across the continent cannot be ignored, reopening sectors and general fundamentals are still providing issuers with a strong operating tailwind. As a result, defaults are expected to remain at historically low levels this year. We do acknowledge that a more defensive sector allocation might become our preferred approach toward year-end if downside risks persist, but so far, financial reporting from loan issuers has remained strong. Returns for European loans thus far in 2022 have been resilient and have clearly outperformed other European risk assets, emphasizing solid fundamentals. CLOs have sailed through volatility and continued to issue at a decent pace, adjusting at times to widening spreads with structural adjustments, but overall benefiting from a functional market. As we’ve seen in the past, the expected rate hikes by the Fed and resulting increased costs of hedging USD-denominated CLO AAAs for Japanese investors might incur a reallocation toward euros, which might drive further demand for European CLOs and therefore bring additional inflows to bank loans in the region.

With regard to CLO equity, it may be one of the few investment choices that could provide generous income in excess of inflation. CLO equity can provide investors who have a buy-and-hold mentality with an attractive and relatively stable source of income. Since 2014, CLO equity averaged 4.4% in quarterly distributions—providing an annual income well above the rate of inflation, potentially in the mid-teens after fees and expenses, according to J.P. Morgan and Intex as of December 31, 2021. Within investors’ asset allocations, CLO equity can provide an increase in returns, reduce the J-curve of other private equity strategies and offer diversification benefits. The return and volatility profile for a 5% allocation to CLO equity can potentially enhance an investor’s return with limited to no increase in volatility when the sources of funds come from equity and alternative strategies. For those investors reducing fixed-income allocations, keeping in mind that CLO equity historically has been negatively correlated with US Treasuries, the impact on asset allocation strategies will likely increase returns but also volatility. As investors are seeking income, especially enough to offset the impact of higher inflation, an investment in CLO equity managed by an active manager could be a reasonable solution.

Municipals: Positive Credit Trends Contrast Negative Returns YTD
Municipal fundamentals have continued to exhibit strength during budget season, contrasting the record negative YTD returns. According to census data, state and local revenue collections hit a record high $1.9 trillion at 2021 calendar year-end, 15% higher than 2020 record-setting levels. Strong tax growth was driven by increases in Corporate Income Tax Receipts (+58%), Individual Income Tax Receipts (+22%), Sales Tax Receipts (+16%) and Property Tax Receipts (+5%).

Meanwhile, state and local payrolls remain below pre-pandemic levels. As the US labor market continues to demonstrate strength with an additional 1.7 million of nonfarm payrolls added YTD through March, state and local payrolls increased just 24,000 YTD and total state and local payrolls remain 4% below pre-pandemic levels. When paired with record revenue collections, budgetary prudence has contributed to robust growth in state reserves over the prior fiscal year. Elevated cash reserves, along with federal stimulus funds that have yet to be fully distributed and can be allocated through 2026, should ameliorate inflation-driven cost pressures and support a continued trend of upgrades that outpace downgrades over the medium-term. While constructive on credit conditions for the vast majority of the investment-grade municipal market, we are more cautious on select high-yield names, particularly in the project finance and Continuing Care Retirement Community (CCRC) sectors that have limited flexibility to manage through negative economic headwinds.

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

Western Asset’s high-level views across global credit markets.

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 across industries.

Investment-Grade (IG) Credit
We remain cautiously optimistic about corporate fundamentals near-term given the strong starting position while overall domestic economic growth should still be supportive despite additional headwinds emanating from the Russia-Ukraine conflict. We remain vigilant of potential shareholder-friendly activity (e.g., share buy-backs, M&A, etc.) but outside of a few examples of bondholder-unfriendly behavior, we have continued to witness conservative balance sheet management. Valuations temporarily repriced into attractive territory; however, overall spreads quickly retraced in the second half of March to levels that can be described as fair given the increased degree of uncertainty remaining. We continue to maintain overweights to banking, select reopening industries and rising-star candidates where allowed. In Europe, M&A/LBOs/a stretched consumer/supply chains are all key risks we are focused on. Bank balance sheets remain in strong shape with higher rates supportive of profitability. Yields have reached multi-year highs in euro IG bringing a surge in demand for high-quality bonds from insurance companies. We expect IG spreads to perform, but do not expect a reversion to the 2021 tights. We find most value in subordinated financials and REITs.

Emerging Markets (EM)
The unevenness of the post-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 could be vulnerable to market swings. Finally, EM primary issuance, priced at a concession to secondary and DM levels, currently offers attractive relative value; we continue to watch for more dislocated pockets of value in HY-rated corporate issuers.

Mortgage and Consumer Credit
Mortgage credit and asset-backed securities (ABS) spreads have widened and remain at wider levels relative to pre-Covid, and currently are at their widest level over the past year in spite of the overall strength of the US economy due to the remaining uncertainties and unevenness of the recovery. Consumer fundamentals have also improved post-Covid with increased savings rates, declining revolving consumer credit balances, and lower interest rates, which together have decreased debt burden levels to the lowest in 20 years. We see attractive opportunities in consumer ABS sectors focused on the prime quality borrowers. After a challenged year for commercial real estate with revenues limited due to mandated stay-at-home orders, the reopening of retailers and leisure travel has provided a tailwind for the industry. The team believes mortgage credit offers value backed by real assets that benefit from a rising inflation environment and can generate attractive risk-adjusted returns.

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 conservative stress tests over the last decade provide strong pillars to our thesis that banks have grown into a simpler, safer and stronger industry. The strongest banks globally should thrive in a world with sound economic growth, generally higher interest rates, extremely low credit costs and robust capital market activities. We remain constructive on banks from a fundamental and relative value perspective in 2022 based on our expectations for the economy, earnings, credit ratings and technicals.
Energy
Key Observations Oil prices remain at elevated levels as demand has returned to almost pre-Covid levels combined with the continued geopolitical tensions and no additional supply coming on the market from OPEC or from the US shale industry. The domestic oil industry continues to be disciplined amid the uncertainty as their focus remains on shareholder returns and rebuilding investor sentiment. Capital budgets are increased on higher inflation rather than production growth. Inventories (crude and product) remain relatively tight leading to a continued tighter, more balanced market. Volatility in prices is expected to remain in addition to continued backwardation. Our view of the continued cyclical upswing and longer-term energy transition remains.
Food & Beverage
Key Observations As Covid fears fade, consumers are returning to eating out, which benefits restaurants and foodservice companies. However, during the second quarter of 2022, food and beverage companies are suffering from a sequential acceleration of wage and input cost inflation due to higher energy and commodity prices as a result of the Russia and Ukraine conflict. Thus far, consumers have been mostly willing to accept and absorb thanks to accumulated savings and higher wages. In addition, food and beverage companies face ongoing elevated freight and transportation costs that may pressure margins in 2Q22, but should wane in the back half of 2022, due to easier comparisons and an expectation of more balanced supply/demand dynamics.
Gaming
Key Observations Higher levels of inflation are expected to impact consumer spending trends on discretionary items such as gaming. That stated, domestic regional operators and Las Vegas Strip operators will likely post record earnings over the course of the next several weeks given consumers increasing willingness to travel and the receipt of government stimulus checks which provided the pathway for improved occupancy rates and gross gaming revenue trends. Asia-based operators continue to struggle with the prohibitive COVID-19 travel restrictions, particularly those in mainland China.
Health Care
Key Observations In the IG space, we anticipate issuance of $100 billion in 2022 versus 2021 issuance levels of $94 billion on muted M&A. YTD, $24 billion has been issued versus $16 billion in 1Q21. With 25% of IG pharma reporting thus far, the focus for M&A will continue to be bolt-on to medium-sized deals due to the tough regulatory environment. Inflationary pressures from higher transportation costs and shortages in electronic components are very manageable in the short to intermediate-term. The Russia/Ukraine conflict poses a limited impact on the healthcare sector as the majority of pharma and medical device companies derive between 0.5%-1.0% of sales from Russia. In HY, we believe 2022 will be the year of rising stars (e.g., we expect HCA, CNC and MPW to be upgraded to investment-grade). All three credits represent almost 100 bps of the high-yield index. We continue to maintain an overweight positioning to HY hospitals and remain selective here. Medicaid expansion efforts should continue to benefit payor mix/profitability and cost headwinds should be manageable broadly speaking. We do expect margin pressure into 1H22 due to a rise in COVID-19 volumes and continued wage inflation pressures.
Metals & Mining
Key Observations Metals markets have paused with increased geopolitical tension, a resurgence of Covid cases in China, talks of recession and subsequent reevaluation of demand outlook. While inflation is good for commodities, the Fed’s interest is in tackling it via raising rates. While the short-term outlook must deal with these uncertainties, the medium to longer term outlook remains intact: demand should be buoyed with the energy transition and supply in question given the chronic underinvestment of the industry and time lag in bringing on new supply. Managements continue to remain restrained with capital allocation, increasing with inflation but not much more than that. Tighter balances are expected to prevail in the future and should support prices hence earnings and cash flows. We continue to watch for consolidation to return.
Pharmaceuticals
Key Observations In HY 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 US retailers reported mixed quarterly results as companies that sourced their merchandise domestically avoided most of the supply-chain issues. However, retailers who sourced from Asia due to the closure of manufacturing facilities as a result of omicron, as well as delays at congested ports that suffered from labor and equipment shortages. Retailers are attempting to pass along higher freight and transportation costs, but the delayed arrival of merchandise resulted in missed sales and the deleveraging of fixed costs. However, thanks to the substantial monetary and fiscal stimulus, demand for goods has been strong as reflected in the fact that US retail sales are 22% higher than two years ago. In the UK, we are increasingly mindful of macro headwinds such as inflationary pressures, rising energy prices and reversal of fiscal support (e.g., UK National Insurance price hike), which may put new constraints on consumer spending power and consequently retail revenues.
Telecommunications & Media
Key Observations We are seeing an uptick in competitive rivalry across a number of telecoms markets including notably the US, but do not anticipate any near-term, material impact on issuer credit quality. Instead we remain focused on the persistent divergence in sector equity valuations across private and public markets. On the one hand, this has left many issuers vulnerable to LBO/take-private approaches. On the other hand, it presents an opportunity for low IG-rated, asset-rich issuers to carve out/sell infrastructure, including wireless towers, fiber and possibly even spectrum, and use proceeds to shore up balance sheets. Separately, the rise of independently governed European wireless towers operators continues and we expect another year of significant bond issuance from this subsector. In the global media sector, as in 2021, we expect issuers to benefit once more from the resurging global ad spend.
Transportation
Key Observations Demand for air travel rapidly accelerated in Q2 as omicron has faded, offices are reopening and travel restrictions are lifted. According to the US TSA, passenger traffic throughput at US airports has recovered to 91% of 2019 levels. Volatile and rising fuel costs represent a headwind for the airlines, although the airlines are diligently passing along the fuel costs to customers, who are willing and able to absorb higher travel costs thanks to accumulated savings, higher wages and a spending shift from goods to services. The US legacy carriers reported solid 1Q22 results and raised their revenue, margin and free cash flow outlook for 2Q22 due to robust consumer demand and an accelerating return of business and international travel.
Utilities
Key Observations The domestic industry remains focused on the regulated model and management teams look to grow while rationalizing generation (merchant and other) and non-traditional businesses like natural gas distribution; Transmission and distribution investment remains favored. Capital budgets continue to be dominated by climate change agendas and are expected to be elevated for the foreseeable future. Managements are pushing the envelope regarding leverage and rating agency downgrade thresholds. Consequently, the strength of regulatory and political relationships remains key so that recoup of investments can be recovered in a timely manner.
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 conservative stress tests over the last decade provide strong pillars to our thesis that banks have grown into a simpler, safer and stronger industry. The strongest banks globally should thrive in a world with sound economic growth, generally higher interest rates, extremely low credit costs and robust capital market activities. We remain constructive on banks from a fundamental and relative value perspective in 2022 based on our expectations for the economy, earnings, credit ratings and technicals.
Energy Oil prices remain at elevated levels as demand has returned to almost pre-Covid levels combined with the continued geopolitical tensions and no additional supply coming on the market from OPEC or from the US shale industry. The domestic oil industry continues to be disciplined amid the uncertainty as their focus remains on shareholder returns and rebuilding investor sentiment. Capital budgets are increased on higher inflation rather than production growth. Inventories (crude and product) remain relatively tight leading to a continued tighter, more balanced market. Volatility in prices is expected to remain in addition to continued backwardation. Our view of the continued cyclical upswing and longer-term energy transition remains.
Food & Beverage As Covid fears fade, consumers are returning to eating out, which benefits restaurants and foodservice companies. However, during the second quarter of 2022, food and beverage companies are suffering from a sequential acceleration of wage and input cost inflation due to higher energy and commodity prices as a result of the Russia and Ukraine conflict. Thus far, consumers have been mostly willing to accept and absorb thanks to accumulated savings and higher wages. In addition, food and beverage companies face ongoing elevated freight and transportation costs that may pressure margins in 2Q22, but should wane in the back half of 2022, due to easier comparisons and an expectation of more balanced supply/demand dynamics.
Gaming Higher levels of inflation are expected to impact consumer spending trends on discretionary items such as gaming. That stated, domestic regional operators and Las Vegas Strip operators will likely post record earnings over the course of the next several weeks given consumers increasing willingness to travel and the receipt of government stimulus checks which provided the pathway for improved occupancy rates and gross gaming revenue trends. Asia-based operators continue to struggle with the prohibitive COVID-19 travel restrictions, particularly those in mainland China.
Health Care In the IG space, we anticipate issuance of $100 billion in 2022 versus 2021 issuance levels of $94 billion on muted M&A. YTD, $24 billion has been issued versus $16 billion in 1Q21. With 25% of IG pharma reporting thus far, the focus for M&A will continue to be bolt-on to medium-sized deals due to the tough regulatory environment. Inflationary pressures from higher transportation costs and shortages in electronic components are very manageable in the short to intermediate-term. The Russia/Ukraine conflict poses a limited impact on the healthcare sector as the majority of pharma and medical device companies derive between 0.5%-1.0% of sales from Russia. In HY, we believe 2022 will be the year of rising stars (e.g., we expect HCA, CNC and MPW to be upgraded to investment-grade). All three credits represent almost 100 bps of the high-yield index. We continue to maintain an overweight positioning to HY hospitals and remain selective here. Medicaid expansion efforts should continue to benefit payor mix/profitability and cost headwinds should be manageable broadly speaking. We do expect margin pressure into 1H22 due to a rise in COVID-19 volumes and continued wage inflation pressures.
Metals & Mining Metals markets have paused with increased geopolitical tension, a resurgence of Covid cases in China, talks of recession and subsequent reevaluation of demand outlook. While inflation is good for commodities, the Fed’s interest is in tackling it via raising rates. While the short-term outlook must deal with these uncertainties, the medium to longer term outlook remains intact: demand should be buoyed with the energy transition and supply in question given the chronic underinvestment of the industry and time lag in bringing on new supply. Managements continue to remain restrained with capital allocation, increasing with inflation but not much more than that. Tighter balances are expected to prevail in the future and should support prices hence earnings and cash flows. We continue to watch for consolidation to return.
Pharmaceuticals In HY 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 US retailers reported mixed quarterly results as companies that sourced their merchandise domestically avoided most of the supply-chain issues. However, retailers who sourced from Asia due to the closure of manufacturing facilities as a result of omicron, as well as delays at congested ports that suffered from labor and equipment shortages. Retailers are attempting to pass along higher freight and transportation costs, but the delayed arrival of merchandise resulted in missed sales and the deleveraging of fixed costs. However, thanks to the substantial monetary and fiscal stimulus, demand for goods has been strong as reflected in the fact that US retail sales are 22% higher than two years ago. In the UK, we are increasingly mindful of macro headwinds such as inflationary pressures, rising energy prices and reversal of fiscal support (e.g., UK National Insurance price hike), which may put new constraints on consumer spending power and consequently retail revenues.
Telecommunications & Media We are seeing an uptick in competitive rivalry across a number of telecoms markets including notably the US, but do not anticipate any near-term, material impact on issuer credit quality. Instead we remain focused on the persistent divergence in sector equity valuations across private and public markets. On the one hand, this has left many issuers vulnerable to LBO/take-private approaches. On the other hand, it presents an opportunity for low IG-rated, asset-rich issuers to carve out/sell infrastructure, including wireless towers, fiber and possibly even spectrum, and use proceeds to shore up balance sheets. Separately, the rise of independently governed European wireless towers operators continues and we expect another year of significant bond issuance from this subsector. In the global media sector, as in 2021, we expect issuers to benefit once more from the resurging global ad spend.
Transportation Demand for air travel rapidly accelerated in Q2 as omicron has faded, offices are reopening and travel restrictions are lifted. According to the US TSA, passenger traffic throughput at US airports has recovered to 91% of 2019 levels. Volatile and rising fuel costs represent a headwind for the airlines, although the airlines are diligently passing along the fuel costs to customers, who are willing and able to absorb higher travel costs thanks to accumulated savings, higher wages and a spending shift from goods to services. The US legacy carriers reported solid 1Q22 results and raised their revenue, margin and free cash flow outlook for 2Q22 due to robust consumer demand and an accelerating return of business and international travel.
Utilities The domestic industry remains focused on the regulated model and management teams look to grow while rationalizing generation (merchant and other) and non-traditional businesses like natural gas distribution; Transmission and distribution investment remains favored. Capital budgets continue to be dominated by climate change agendas and are expected to be elevated for the foreseeable future. Managements are pushing the envelope regarding leverage and rating agency downgrade thresholds. Consequently, the strength of regulatory and political relationships remains key so that recoup of investments can be recovered in a timely manner.