"Against an uncertain market backdrop, we believe the best approach for investors in active fixed income credit includes a core allocation to higher-quality, defensive credits that are less sensitive to a weakening global economy."
Head of Vanguard Europe’s Fixed Income Specialist team
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 hikes1.
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”2, 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.
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 prices3, as investors demand higher yields on bank debt amid concerns that a recession could come earlier and run deeper than previously anticipated4.
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.
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. Fundamental analysis and a rigorous security selection process are also critical to managing downside risk during periods of market volatility.
As the dislocation in credit markets continues to develop, this bottom-up approach to security selection has a distinct advantage, providing investor portfolios with diversified exposure that can help absorb the shocks when markets grow turbulent.
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.
2“Beats” refers to companies whose earnings surpassed, or “beat”, analysts’ expectations for the quarter.
Investment risk information
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.
Some funds invest in emerging markets which can be more volatile than more established markets. As a result the value of your investment may rise or fall.
Funds investing in fixed interest securities carry the risk of default on repayment and erosion of the capital value of your investment and the level of income may fluctuate. Movements in interest rates are likely to affect the capital value of fixed interest securities. Corporate bonds may provide higher yields but as such may carry greater credit risk increasing the risk of default on repayment and erosion of the capital value of your investment. The level of income may fluctuate and movements in interest rates are likely to affect the capital value of bonds.
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