Taking Selective Risk in Credit

Even as sovereign bond yields were volatile over the past year, the spread between them and credit yields has tightened steadily. We cut global investment grade (IG) credit to underweight on a tactical, six- to 12-month horizon last September after preferring it over stocks and high yield since mid-2022. That change funds risktaking in pockets of credit where the risks seem better compensated for. We favor high yield and stay neutral: Its yield is attractive and returns are less sensitive to interest-rate swings. Regional differences underpin why we prefer European credit overall. U.S. IG and high yield credit spreads are further below their 10-year average than European peers. See the chart. European spreads have underperformed since 2020 partly due to a different sector composition and weaker growth in Europe, in our view. Yet we think the excess yield in European credit compensates for the risks.

We see markets embracing a more supportive near-term macro outlook. In the U.S., we expect inflation to fall near the Fed’s 2% target this year before resurging beyond 2024. We went overweight U.S. stocks this year because we think the upbeat risk appetite can persist and broaden out beyond artificial intelligence, until resurgent inflation comes into view later this year. Robust U.S. growth, nearing Fed rate cuts and falling inflation have lessened the market’s recession worries. That’s good news for emerging market (EM) assets, in our view. We’re overweight EM hard currency debt – mostly denominated in U.S. dollars – as spreads look more fairly valued than U.S. high yield. We see broader credit spreads staying tight for now given the supportive risk-taking backdrop, and strong demand for new issuance of U.S. IG and U.S. high yield credit bonds.

Yet we see a risk that could cause high yield spreads to widen as markets price in more credit risk. About 10% of the market value of euro area high yield debt is maturing in 2025, 6% of U.S. high yield debt – and even more the next year, BlackRock Aladdin data show. We find that’s not an exorbitant amount, and even the lowest-rated high yield issuers have been able to refinance debt this year. Still, refinancing at higher interest rates may challenge operating models that assumed rates would stay low, in our view. IG companies also have debt maturing, but we think their stronger balance sheets are more flexible.

A year after a few U.S. regional banks collapsed, we have seen the funding challenges higher interest rates create. We’re monitoring the impact of higher rates and maturing debt on commercial real estate. The sector will likely face more pain, but we think it will be manageable as the reset to lower valuations occurs over multiple years. We see a more supportive nearterm macro backdrop. Firms that need to refinance may turn to private credit as banks cut back on lending. We prefer private market credit over public on a strategic horizon of five years and longer because we think demand will rise and higher yields better compensate for risk. Yet private markets are complex, with high risk and volatility, and aren’t suitable for all investors.

Bottom line: We get granular as the near-term macro outlook improves the environment for risk-taking. We’re overweight U.S. stocks, euro area high yield and EM hard currency debt. We also see opportunities in private credit as public debt matures.

Market backdrop

The S&P 500 and Nasdaq keep marching higher, with both indexes hitting new all-time highs last week. U.S. Treasury yields retreated even as markets priced out more Fed rate cuts given resilient growth and sticky inflation – and now see just three quarter-point cuts this year. We still see inflation on a rollercoaster that the market could wake up to later in the year. The U.S. PCE inflation data confirmed that inflation will likely settle closer to 3% after falling toward the Fed’s 2% target this year.

Tracking five mega forces

Mega forces are big, structural changes that affect investing now – and far in the future. As key drivers of the new regime of greater macroeconomic and market volatility, they change the long-term growth and inflation outlook and are poised to create big shifts in profitability across economies and sectors. This creates major opportunities – and risks – for investors. See our web hub for our research and related content on each mega force.

1. Demographic divergence: The world is split between aging advanced economies and younger emerging markets – with different implications.
2. Digital disruption and artificial intelligence (AI): Technologies that are transforming how we live and work.
3. Geopolitical fragmentation and economic competition: Globalization is being rewired as the world splits into competing blocs.
4. Future of finance: A fast-evolving financial architecture is changing how households and companies use cash, borrow, transact and seek returns.
5. Transition to a low-carbon economy: The transition is set to spur a massive capital reallocation as energy systems are rewired.

Granular views

Six- to 12-month tactical views on selected assets vs. broad global asset classes by level of conviction, March 2024.

Our approach is to first determine asset allocations based on our macro outlook – and what’s in the price. The table below reflects this and, importantly, leaves aside the opportunity for alpha, or the potential to generate above-benchmark returns. The new regime is not conducive to static exposures to broad asset classes, in our view, but is creating more space for alpha.

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