European credit: Staying cautious

The following blog is an extract from our latest Active Fixed Income Outlook.

The past: what just happened? 

Developed market government bond yield curves fell lower and steepened significantly in the third quarter of 2024 as they priced in a faster pace of interest rate cuts now the easing cycle has begun. European investment grade credit spreads remained broadly unchanged, though there were short-lived periods of significant volatility around the European Parliamentary and French elections, US labour market data prints, and the unwinding of Japanese currency-related trades.

Since October 2022, credit spreads have been greatly supported by the volume and consistency of inflows into the asset class, which appear to have accelerated recently despite the fall in yields. This could be down to investors hurrying to lock in yields at their current levels in anticipation of them falling further.

This has also been supportive against the backdrop of the historically largest-ever volume of new bond issuance by this point in the year[1] , and the ECB (European Central Bank) not reinvesting the proceeds from the maturities of bonds it holds. In June, the ECB cautiously began its rate-cutting cycle as backward-looking inflation and inflation expectations data suggested sufficient progress was being made.

The US Federal Reserve has only recently followed on; strong growth in the US had suggested there was no rush to cut and the fear remains that inflation could reaccelerate if they act too soon.

The present: key themes

The conversation in fixed income has long been around whether central banks around the world can bring down inflation without triggering recessions. Markets are currently highly sensitive to data that might suggest labour markets or growth are weakening. Consequently, Euro credit spreads have moved off the tights of the summer and are in our view attractive in comparison to sterling and US dollar spreads. At the time of writing, they’re sitting around the 46th percentile – although we still don’t feel they have priced in the risk of a recession sufficiently[2].

To reflect our cautious view, our portfolios are positioned with a skew towards higher quality, in terms of ratings and parts of the capital structure, and we are using little of our flexibility to reach for portfolio risks outside of the investment universe defined by our benchmark indices. The BBB:A spread differential has recently compressed significantly[3], so the forgone spread from being underweight BBBs versus As is less than it would otherwise have been.

Real estate issuers have performed well as the path of financing costs has improved with expectations of interest rate cuts and banks have seen their spreads compress versus non-financials, so we have been reducing our exposure to issuers in both sectors. As a result, we have more liquidity in the portfolios to allow room to opportunistically buy should a significant sell-off materialise. Other existing themes remain in place, such as our overweight to utilities, underweight to automobile companies, and focus on bottom-up issuer selection.

What could go wrong?

There is a lot of uncertainty at present: inflation is steadily coming down, but if central banks have cut interest rates too early or if geopolitical events cause oil prices to rise, inflation could reaccelerate. Growth appears to be holding up and labour markets haven’t cracked, but that could still happen. The outlook for the US economy may be affected by the result of the election in November, and it remains to be seen if asset class flows will be affected by changes to investors’ asset allocations as yields trend downwards. To echo the comments from last quarter: these are things to prepare for rather than predict…

Outlook

We expect market nerves to continue through the fourth quarter and that ‘no news will be good news’ if data releases continue to not provide any deviation from survey expectations. Corporate strength largely hinges on the health of the global economy, so we’ll be looking for clues on broader economic performance in third quarter earnings. We prefer less cyclical sectors and ensure we own credits we are comfortable with based on their fundamentals as we wait to see if the ‘soft landing’ is achieved – or if we need to brace for a ‘hard landing’.

The above blog is an extract from our latest Active Fixed Income Outlook.

[1] Source: Bloomberg as at 24 September 2024
[2] Source: Bloomberg as at 24 September 2024
[3] Source: Bloomberg as at 24 September 2024