Investment Review and Outlook

The long-anticipated recession remains elusive in the face of positive economic data

For more than a year, in news reports and commentaries, forecasters projected recessionary conditions were almost inevitable considering persistent inflation, the Fed’s interest rate hikes, and an inverted Treasury yield curve.

Nevertheless, favorable factors overshadowed pundits’ predictions. Labor demand was strong. Wage growth continued. Consumer sentiment stayed positive. Quarter-to-quarter gross domestic product (GDP) readings showed growth. At the end of June, the Bureau of Economic Analysis adjusted first quarter 2023 GDP up to 2 percent quarter-over-quarter (Q/Q), 0.7 percent higher than its prior reading.

The flow of positive economic data continued through the second quarter. May retail sales surpassed expectations. Durable goods orders increased. Housing starts, building permits, and existing home sales improved.

The mix of news and forward-looking estimates left some market participants wondering where the Fed might go next. Inflation remains above the Fed’s 2 percent long-term target. By the end of the first half of 2023, certain commentators were predicting at least one more fed funds increase in 2023. FOMC meeting minutes released in July indicated the potential for two more fed funds rate increases in 2023.

Favorable economic data indicate resilient consumer spending and confidence, sustaining 2 percent GDP growth, which, while positive, is below potential. Upside risks to growth include stronger than expected job creation, sustained consumer spending, and a wealth effect from rising asset values.

On the other hand, manufacturing and services ISMs are nearing contraction, capex growth has turned negative, lay-offs are rising in select sectors, and corporate profits are set to decline for the third quarter in a row. Downside risks include further price pressure on commercial real estate (CRE), tightened bank lending standards and increasing bankruptcies among small businesses.

Our base case calls for a no growth to mild economic recession over the next 6 to 12 months. We believe the Fed will hike rates once more in July by 25 basis points (bps).

Favorable technicals are a partial offset to softening credit fundamentals and tight valuations. While select opportunities may exist in certain sectors, given the macro backdrop, positioning generally favors a defensive stance as it pertains to quality and beta within the corporate market.

Fundamentals

Regional Bank Spreads Still Notably Wide Versus Comparables

Credit fundamentals are softening, marked by a corporate earnings recession and lingering banking troubles. Consensus estimates look for a third straight quarter of falling profits, as the declines in earnings continues. 

 Concerns over the health of the nation’s wider banking system diminished after the demise of three regional banks earlier in the first half of the year. Larger banks stepped in and the Federal Deposit Insurance Corporation (FDIC) continues to guide what has been an orderly disposition of the failed banks’ assets.

The trajectory of the sector—particularly the regional banks segment—warrants heightened attention moving forward because of its essential role in the course of the economy and its interelationships with other businesses.

Regional bank spreads ended 2Q23 70bps off mid-May wides. However, a substantial valuation gap remains between regionals, money center banks, and non-financial issuers. Until March, regional spreads traded inside of money center banks and non-financial issuers. With the shock of several FDIC seizures, that relationship has shifted notably. 

Regional banks face fundamental headwinds that may impact credit strength. Rating agency outlooks are biased negative across a variety of industries including Banking. However, relative valuations are historically wide and select opportunities may exist.

Large Banks Have Lower Relative Exposure to CRE

Large banks—those with greater than $250 billion in assets—had a lower percentage of CRE loans to assets (5.7 percent) versus all FDIC-insured banks (12.9 percent) at 1Q23.

Large banks had a lower pre-tax returns on equity (ROE) (15.9 percent) versus all FDIC-insured banks (17.6 percent) at 1Q23. But, in three recessionary periods, large banks had higher ROEs.

Large banks and all FDIC-insured banks had comparable regulatory Tier 1 capital and loan net charge-off ratios at 1Q23 and in looking back at three recessionary periods. 

Bloomberg’s Bank Index contains 64 bond issuers. The largest 35 represent 95 percent of the Index’s market value. About 5 percent is issued by banks less than $250 billion in assets.

Corporate Earnings Decline for a Second Consecutive Quarter

For 1Q23, S&P 500 issuers reported a 1.6 percent year-over-year (Y/Y) decline in earnings following a 3.4 percent drop in 4Q22. A total of 81 issuers provided negative guidance for 1Q23, the highest since 3Q19. 

Consensus estimates look for a third straight quarter of falling profits, suggesting a continuation of an earnings recession. S&P 500 earnings are forecast to decline 6.8 percent Y/Y for 2Q23. With continued upward pressure on producer prices, input costs and wages, net profit margins are forecast to come down further to 11.4 percent in 2Q23 from 12.2 percent in 2Q22.

Mergers are down 37 percent Y/Y, as event risk moderated on higher borrowing rates and market volatility. Low event risk and healthy cash balances are a partial offset to weak operating trends.

Technicals

Corporate Supply Increased and Fund Flows Slowed While the IG Corporate Index Yield Increased

For the quarter, IG bond issuance was $389 billion, with fund flows totaling $27 billion. Net issuance was about $170 billion after $219 billion of redemptions.

IG fund flows were about $8 billion in June decreasing from $12 billion in May. Fund flows are about $82 billion year-to-date (YTD). 

In a typically light month, June gross IG supply was $108 billion, up 17 percent Y/Y, with net issuance of $52 billion after $56 billion in redemptions. 

With an expectation of rotation into IG fixed income, we see technicals as a modest positive.

The Bloomberg IG Corporate Index yield ended the quarter at 5.48 percent at June 30, 2023, up 31bps from March 31, 2023.

Valuations

Credit Curves Steepened Reversing Flattening in Prior Quarter

Looking across sectors, IG corporate spreads narrowed by 15bps in 2Q23 finishing at 123bps. BBBs outperformed A-rated bonds in 2Q23, tightening by 18bps and 13bps, respectively.

In a reversal from 1Q23, credit curves steepened. Spreads for bonds with maturities ranging from 1-year to 5-years narrowed 23bps in 2Q23, while spreads on 7- to 10-year maturity bonds tightened 8bps during the same time period. The move wider in 1- to 5-year bond spreads, created opportunities in 1Q23. The reversion in 2Q23, suggested some investors may have recognized their relative cheapness.

IG spreads are not pricing in a typical earnings recession. Attractive all-in yields may continue to draw fund flows and keep spreads tighter than fundamentals may suggest.

Sustainable Spotlight

In an interesting development on the sustainable investing front, Bloomberg report on July 5 that, “Almost $350 billion was raised from green bond sales and loan arrangements in the first half of this year, compared with less than $235 billion of oil, gas and coal-related financing.” The report noted that last year, the ratio was roughly $300 billion in green bond issuance versus $315 billion fossil fuels in the same period last year.

Breckinridge offered its investor perspectives in the development of green bond disclosure guidelines developed by the California Green Bond Market Development Committee. More detail on the guidelines and Breckinridge’s involvement in their promulgation can be found in the article Breckinridge Contributes To New Green Bond Disclosure Guidelines.

In an area of environmental concern gaining increased attention, the Global Biodiversity Framework signed at the UN’s December 2022 COP 15 conference elevated the profile of biodiversity. Countries at the conference reached consensus to "halt and reverse biodiversity loss" and put “nature on a pathway to recovery" by 2030. Their agreement helps to highlight the relationship between preservation and restoration of natural capital and slowing climate change as well as mitigating its physical risks. In addition, the framework advances appreciation of the credit investment materiality represented by biodiversity risks. More about the agreement and biodiversity’s critical role in investing is available in the article Elevating Biodiversity’s Profile Reveals Interrelationships with Climate Risks.

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