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U.S. IG & Lev Fin 2024 Outlook: Hurry Up and Wait
Winnie Cisar - Global Head of Strategy
Zachary Griffiths - Head of IG & Macro Strategy
Logan Miller - Head of European Strategy
Brian Perez - Credit Strategy Analyst
Kathleen Tang - Strategy Analyst
EXECUTIVE SUMMARY
- We upgrade U.S. IG and HY to Overweight allocations with YE24 spread targets of 100 bp and 350 bp, respectively. There is plenty of cash still on the sidelines that we expect to be a technical tailwind, particularly early in the year, as the Fed begins policy normalization.
- We initiate on U.S. Leveraged Loans. Fundamentals are more strained for lev loan issuers compared to HY bond issuers. Our preference is for HY bonds when adding credit risk to portfolios. Careful issuer and security selection will be particularly important in 2024 after a banner year for lower-rated credits and loans in 2023.
- In our base case scenario, U.S. IG produces excess and total returns of 1.8% and 10.7%, respectively. HY returns 12.3%, while we expect Leveraged Loans to return 10.2%, underperforming the HY index after outperforming in 2021-23. On a probability weighted basis US IG, HY and Leveraged Loans return 5.5%, 7.8% and 5.6%, respectively.
- Credit looks cheap to equities, and all-in yields at historically elevated levels should attract cash into IG and HY credit. IG investors that were underweight the benchmark in favor of cash likely made it through the year unscathed given high and rising rates on cash products in 2023. Under-risked HY investors felt more pain as lower-rated credits materially outperformed, leading to HY returns well above those offered on cash.
- We expect duration to perform well as rates fall across the curve, driven in part by 100 bp of Fed rate cuts. We have the first cut penciled in at the March 2024 meeting and expect the Treasury curve to bull steepen. Our YE24 yield targets are 3.50% on the 2y and 3.75% on the 10y.
- We expect HY defaults to rise modestly to 3.5% at YE24. Fundamentals should remain solid coming under manageable pressure from still elevated, albeit receding, borrowing costs. Management teams remain focused on responsible balance sheet policy, with few issuers intentionally releveraging. More existing debt will be recast at higher coupons, but plenty of near-term maturities have been proactively managed in 2023.
- We maintain our benign economic forecast for below-trend growth of 1-1.5%. This coupled with a drop in consumer spending, particularly on services, should push the core PCE deflator down to roughly 2.25% at the end of 2024.
- Our benign economic and financial market outlook should drive higher, but manageable, U.S. IG and HY issuance at $1.3 trillion and $250 billion, respectively. We look for a flat year for Leveraged Loan issuance at $225 billion.
KEY EXPECTATIONS AND FORECASTS FOR 2024
Rates:
- Fed cuts rates 100 bp to 4.25-4.50% at YE24. We are sticking with our base case that the Fed delivers the first 25 bp rate cut in March and subsequent cuts come at every other meeting following. This view is predicated on inflation continuing to decline — we expect the core PCE deflator to finish 2024 around 2.25%. Even with this level of rate cuts, the real policy rate (nominal Fed funds less core PCE deflator YoY) is modestly higher at the end of 2024 than it is today. Recent economic data show inflation cooling and the labor market coming into better balance while Fed policymakers have gotten less hawkish, leading us to believe most policymakers want to avoid a much tighter real policy rate in 2024.
- 10y Treasury yield falls to 3.75%. We look for the real yield to decline to closer to 1.50% as the Fed begins normalizing its policy stance and economic growth slows. We expect breakeven inflation expectations to hold mostly steady at around 2.25%. Our call is for the economy to decelerate to below-potential growth in 2024 as fading excess savings, cost of living headwinds, student loan payment resumption and tighter credit standards at commercial banks weigh on growth. A key risk to our Treasury forecast is heavy nominal coupon Treasury supply. Treasury’s borrowing needs in aggregate are downshifting modestly, but Treasury will rely heavily on coupon notes and bonds following heavy bill issuance in 2023. While the fiscal deterioration narrative seems to have faded from the fever pitch it reached in August-October, the technical headwind of heavy supply could put renewed upward pressure on yields. We expect that the Fed will continue balance sheet normalization even after the first rate cut, and potentially through the first several rate cuts, which adds to Treasury’s “privately-held net marketable borrowing” needs. Nonetheless, we expect the shift in monetary policy stance to have a larger impact on Treasury yield levels and the shape of the curve, consistent with historic precedent.
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