This year, we have held – and continue to hold – a positive bias on credit markets. This has been driven by our macro scenario of a robust and sustained global growth recovery as economies normalise following the vaccine rollout, coupled with the significant policy support coming from both monetary and fiscal authorities which should allow global growth to exceed its pre-Covid trend.
Crucially, we are seeing this strength in activity at macro level play out at company level as well, resulting in impressive corporate earnings and improving credit fundamentals across regions and sectors, which adds to our conviction of being invested in credit markets.
This environment is one in which the higher beta segments of the market can outperform and in which we believe credit compression can take place. High-yield spreads should benefit as the most severely impacted sectors from the pandemic continue to recover, whilst we also think that subordinated financial debt is providing an attractive opportunity given strong fundamentals in the banking sector and resilient earnings throughout the pandemic.
As regards corporate earnings, US investment-grade companies had a record earnings season in Q2 21, with around 85% of companies beating earnings expectations.
Companies have seen a sharp rebound in their revenues and earnings compared with Q2 20, which are, on average, now also significantly above their pre-crisis (Q2 19) levels. The recovery has been led by cyclical sectors, including energy, materials, autos and industrials, which have seen the strongest year-on-year improvements. From a credit metrics standpoint, improving earnings, combined with continued prudent balance sheet management, particularly in those sectors worst hit by the pandemic, has led to a drop in net leverage. As earnings further normalise in the coming quarters and balance sheet discipline is sustained in the face of uncertainty around Covid variants, we expect leverage to tick down further.
In Europe, fundamentals have continued to recover for non-financial issuers, with leverage also declining at the start of the year. Strong demand and pricing have raised earnings above pre-crisis levels in cyclical sectors. Companies have typically raised or kept their financial guidance for the year, confirming their own confidence in the outlook. Although share buy-backs are set to increase, they will be financed by free cash flow rather than new debt.
Therefore, we also expect deleveraging to continue in the coming quarters against a favourable backdrop in Europe.
As previously mentioned, we prefer subordinated financial debt, where Q2 proved to be another good quarter for banks, beating market expectations once again. This was generally driven by better revenues in the various capital market divisions, especially equity trading and M&A, whilst loan loss provisions continued to surprise on the upside. Several banks in the US and UK released provisions in Q2, but there have also been some provision releases from several continental European banks. Importantly for financial fundamentals, capital ratios have remained solid and did not deteriorate during the pandemic.
Taken together, both financial and non-financial earnings have surprised on the upside across regions and sectors, confirming our positive bias towards credit markets that has been driven by our macro scenario. As the macro environment continues to recover, we expect credit markets to continue to perform and are positioned accordingly.
