Boutaina Deixonne, Head of Euro IG and HY Credit at AXA IM, reviews 2023 for the Euro credit market and looks ahead to 2024
2023 has been a tough year for risky assets, notably investment grade (IG) and high yield (HY) credit. Indeed, bond markets faced high volatility in the rates markets, affected by some contradictory data in terms of inflation and economic growth. Indeed, growth in Europe, but more importantly in the US, was more resilient than expected. Meanwhile underlying inflation struggled to fall during the first six months of the year. This forced central banks in Europe and the US to continue to increase their key rates and to maintain a hawkish stance aimed at cooling inflation.
Fears of higher inflation and weaker growth have been the biggest themes this year as central banks were forced to raise policy rates. In this context, we saw a huge volatility in the rates market, with the Bund rising to 2.7% in March and then flirting with 3% at the start of the fourth quarter. Rates in the US and the UK have experienced the same trajectory as central banks have maintained a very hawkish message to fight inflation at the expense of growth.
The credit asset class was also impacted by the crisis in US regional banks, with the bankruptcy of Silicon Valley Bank (SVB) and the Credit Suisse debacle which brought in its fears of contagion in the banking sector.
Despite these movements, the Euro investment-grade credit market remained almost stable ending the year at 88 basis points (bps), with an outperformance of high-beta sectors such as real estate, financial subordinated debt and hybrid corporates, but also cyclical sectors like autos. The high yield market also surprised positively with a tightening of almost 60bps to 317bps thanks to solid market technical parameters. HY real estate was the underperformer while retail, automotive and media outperformed. Thus, credit was able to record a satisfactory total return of 8% for IG and 12% for HY.
Corporate earnings remained relatively resilient throughout the year with some deceleration in the third quarter of 2023, particularly for sectors such as chemicals. As for financial institutions, results continued to surprise positively with growing net interest income, adequate asset quality and solid capitalisation ratios. We expect fundamentals to deteriorate slightly over the coming months, while Q4 earnings should cautiously remind markets of persistent pressures on margins.
After a complicated 2022, last year was marked by a recovery in the asset classes inflows thanks to better yields, notably towards intermediate and long maturity funds. In high yield the picture is less rosy with ongoing outflows throughout the year, although this trend changed slightly in Q4 thanks to a resumption of soft-landing rhetoric.
Despite interest rate market volatility in Q3 and the SVB/Credit Suisse shock in March, the primary market was dynamic with a gross issuance of nearly 555 billion euros, dominated by non-financials at almost 55%. In total, new issuance increased by 15%, 20% for corporates and 9% for financials. Utilities (10%), Automotive (10%) were the most represented sectors this year, while real estate and energy were the least represented. The hybrid market saw an increase of new issuance by 20% vs. 2022 to €14 billion on the back of refinancing needs following calls and tenders.
Focus on December
December was another positive month for risky assets. Indeed, a dovish Federal Open Market Committee (FOMC) drove a strong rally across equities, rates and credit, pushing the 10Y UST below 4% and the 5Y Itraxx Xover CDS close to 310bps. Weaker than expected US and European inflation contributed to a supportive environment, even though the slowing rally at the end of the month reflects doubts over whether the aggressive pace of rate cuts that were priced in since late November in the US and Europe is warranted for 2024.
The BofA Merrill Lynch index tightened by another 2bps to 88bps, with the outperformance of real estate, financial subordinated debt and corporate hybrids. Defensive sectors lagged the rally notably consumer goods, healthcare and utilities.
Central banks have again been in the driver seat this month. The Fed left the Fed Funds target rate unchanged at 5.25-5.50% by a unanimous decision, in line with market expectations. Powell made some minor adjustments to the economic forecasts and to the economic situation, mentioning that inflation has eased over the past year but remains elevated. However, there was a shift in the tone as Mr. Powell also emphasised the risk that rates stay too high for too long. He said the FOMC had preliminary discussions about cuts and was wary of “making mistake” of “holding on for too long”, leading to a surge in risky assets. We, therefore, continue to expect rate cuts starting next June, with the risk tilted towards a somewhat earlier start given the recent data flow.
As such, the ECB meeting was largely uneventful. Despite a relatively hawkish speech from Mrs. Lagarde, rates and credit markets continued their post-Fed rally. The last sessions of the month were marked by hawkish interventions by members of the Fed and the ECB who notably showed their disagreement with the market's aggressive expectations of a reduction in key rates. Having said that, risky assets were holding up. The bond markets remained well oriented with the US 10-year rate finishing the year at 3.88% and the German 10-year rate stood at 2.02%. Although markets are optimistic about the future, there is a risk of a correction if central banks delay lowering their policy rates, which depends on how quickly inflation falls.
The primary market is usually modest in December, and this month was not an exception with nearly €5 billion issued in investment-grade and €2 billion issued in high yield. Activity has been very modest this month.
As we enter 2024, we expect that the macro environment will result in a weaker growth and lower inflation, leading to potential interest rate cuts from major central banks throughout the year. We continue to strive for a soft landing of the economies, particularly in the US where inflation is decreasing without any major damages to the job market. In Europe, the situation is more intricate. On one hand, inflation is falling rapidly, but on the other, some economies such as Germany experienced a contraction in Q3 2023, increasing the risk of a recession. As such, we do not rule out some volatility in the rates and credit markets in H1. Having said that, we believe that rates are unlikely to be the same headwind this year, and the recent back-up in rates should support total return prospects and improve market technicals with stronger demand.
After the strong rally experienced in both rates and credit markets in Q4, we start 2024 with a prudent positioning towards high beta sectors such as subordinated financials and corporate hybrids. We have marginally increased the proportion of cash held in the portfolios, notably to be used in the primary markets. In terms of duration, we have reduced our exposure to a more neutral stance.