Vanguard Active Fixed Income Perspectives provides views from the desks of Vanguard’s Fixed Income Group (FIG) which manages $445 billion in actively managed fixed income strategies for investors around the world (as at December 31st 2022).
In this, their latest market assessment, Kunal Mehta, Head of Vanguard Europe’s Fixed Income Specialist team, and Andreas Nagstrup, Credit Research Analyst, explain why they remain cautious despite a better-than-expected first quarter earnings season.
The recent first quarter earnings season delivered robust results for European corporates, with many companies reporting strong order books and resilient consumer demand despite the pass-through of inflationary price hikes.
The better-than-expected earnings were driven in part by many issuers’ ability to pass along higher energy and basic materials costs to consumers through increased prices. Consumer cyclicals saw the highest number of “beats” (companies whose earnings surpassed, or “beat”, analysts’ expectations for the quarter), led by the automotive sector. The easing of pandemic-related global supply chain bottlenecks boosted earnings for automakers, with many reporting increases in sales volumes while still retaining strong pricing power and healthy near-term order books.
Despite the buoyant start to the year, earnings guidance going forward was less sanguine, with fears of an economic slowdown tempering management expectations. In the financials sector, more modest forecasts sent signals that earnings have likely already peaked; here, the recent banking crisis and growing concerns about asset quality deterioration, especially in the commercial real estate sector, began to bite many banks’ bottom lines – a trend we expect to grow stronger through to the end of the year.
Overall, while we expect corporate fundamentals in most sectors to remain resilient for the next few months, our outlook for the end of the year and into 2024 remains in the balance – and largely depends on whether the effects of tighter monetary policy and slowing growth will push the global economy into recession.
What a recession could mean for global credit
We are beginning to see signs of a decoupling in economic and asset-price expectations, as healthier-than-expected economic data have weighed on markets by stoking fears that higher rates will be needed to quell inflation – even at the mercy of pushing the economy into recession. In credit markets, the prospect of higher rates and an economic downturn on the horizon are starting to manifest themselves in asset prices, as investors demand higher yields on bank debt amid concerns that a recession could come earlier and run deeper than previously anticipated.
Should recession strike, we expect greater price dislocation in credit markets, along with a widening of credit spreads, particularly at the lower end of the credit quality spectrum. Currently, we are not seeing a significant dispersion between cyclical or growth-sensitive sectors and non-cyclical sectors; however, we would expect this dispersion to increase as investors demand higher risk premia for more vulnerable sectors in a recession.
Staying disciplined in changing market conditions
Against this uncertain backdrop, we believe the best approach for investors in active fixed income credit is one that focuses on a core allocation to higher-quality, defensive credits that are less sensitive to a weakening global economy.
Attempting to time macroeconomic shifts is notoriously challenging—even for professional active bond fund managers—especially when market conditions are changing and the chances of successfully making broad directional calls is arguably even lower than usual.
The recent divergence in earnings and economic forecasts further demonstrates the difficulties of predicting future market movements. All the more reason why, for active fixed income investors, having a strong core fixed income allocation with a focus on disciplined credit selection can provide a diversified defence against whatever the future holds.
