U.S. investors should expect a sharp decline in earnings guidance and more non-investment grade corporate loan defaults, according to Bruce Richards, chairman and chief executive of Marathon Asset Management, a $24 billion global credit manager in New York.

Stocks have been struggling to find a direction amid signals of cooling inflation, an easing labor market and hawkish calls from the Federal Reserve. Richard’s advice for investors is to “stay cautious, my friend. The best is yet to come.”

In an interview, Richards said he’s held bearish views all year but will probably flip to long-term bullish in 2024, after the Fed stems inflation and markets work out of the massive liquidity bubble created during the pandemic. He predicts inflation may lower to 4% at some point next year, but rates will likely remain “uncomfortably firm for a bit longer than we all hoped for.”

As financial conditions tighten, Richards expects earnings per share and market expectations to drop. 

“A 5% decline in EPS is my base case assumption for 2023,” he added. That’s a significant contrast from analysts’ expectations of a 7% increase in earnings per share for 2023, according to data compiled by Bloomberg Intelligence. Typically, earnings per share tend to fall from 14% to 45% during recessions.

Marathon’s investment team remains cautious on a wide range of industry groups that lack pricing power. The outlook is for earnings per share for homebuilders to fall 30%, with retailers down 20% due to high inventories and cost of goods sold.

Rising interest rates, inflation and supply chain issues add pressure on companies’ ability to pay their debt. The pile of troubled debt outstanding expanded by about $1.3 billion last week following three consecutive weeks of contraction, according to data compiled by Bloomberg. As earnings fall and credit quality worsens, Richards sees a pickup in defaults: “non-investment grade credit default rates can increase from sub 1% to over 4-5% next year.”

Richard expects high-yield spreads to widen and recommends allocating capital to the high-yield bond and levered loan markets.

“We favor shorter duration fixed-rate or floating rate assets with the preference to go up in credit quality,” Richards said. Asset-based lending should do very well in this environment, he added.

One of the biggest risks he sees going forward are cracks in the syndicated leveraged loan and middle market loan spaces. By the end of 2022, he expects rates for non-investment grade corporate loans will be higher than the fixed rate coupons for high-yield bonds, which would be a first in credit-market history. As credit costs rise, many companies will burn cash just to service their debt which could lead to “significant credit downgrades and select defaults,” Richards said.

He also expects a higher default rate for levered loans than for high-yield bonds. 

“The high-yield bond market is now a stronger credit quality market with greater than 50% rated BB in comparison with the syndicated loan market where 75% are rated single-B or worse,” Richards said. “Distressed debt managers will get busy again.”

This article was provided by Bloomberg News.