The forecast-defying strength of the US economy has been one of the key drivers of financial markets in recent quarters, but as economic prospects diverge, Europe is where we see the better relative value in fixed income today.
Looking ahead to the second half of 2024, we believe that market conditions for fixed income on the whole look favourable. Yields across the asset class remain high relative to recent history and central banks are on the cusp of delivering long-awaited interest rate cuts.
However, the global macro environment remains uncertain. There is a packed calendar of elections in the second half of the year at a time when government debt levels are coming under increasing scrutiny. Expected interest rate cuts – already much curtailed since the start of the year – still depend on hard-to-forecast data, and the fall in inflation also remains vulnerable to a volatile geopolitical backdrop.
In our view, a diversified portfolio is the best way of taking advantage of this situation and investors will need to look across geographies for the best value income. On a relative value basis, we see European bond markets as more attractive than the US.
US economic strength has been the dominant theme across financial markets for much of 2024 and 2023, with persistently strong data sending corporate bond spreads tighter, equities to record highs and dashing hopes of multiple interest rate cuts from the Federal Reserve (Fed).
However, certain economic indicators, particularly those that relate to inflation across developed markets, have recently begun to diverge. Having once trailed the Fed in their bid to tame inflation, the European Central Bank (ECB) and Bank of England (BoE) have now jumped ahead on the path to rate cuts.
In our view, Europe’s inflation outlook is clearer than that of the US. The sheer size and scope of COVID-era fiscal and monetary stimulus was far greater in the US than in Europe. The inflationary impact of that stimulus was harder to untangle when disrupted supply chains were also a significant factor, but now that the supply side of the equation has largely recovered, it is becoming more evident that the demand side of the US equation will take longer to rebalance. Consequently, the ECB feels it has greater visibility around inflation’s return to target, which prompted a 25bp rate cut at its meeting in June.
Europe’s growth trajectory has also become more appealing for bond investors. The Eurozone economy is recovering from the energy crisis and successive rate hikes in a resilient manner. Growth is forecast to accelerate from just under 0.5% in 2023 to closer to 1% in 2024, and higher than that the year after.
As a fixed income investor, there is such a thing as too much growth. When growth outstrips expectations for an extended period, this typically brings about inflation and forces central banks to push rates up, causing mark-to-market losses and volatility in fixed income. In theory, “above potential” growth also raises the risk of a more severe economic contraction (a “hard landing”) in the future. Growth in Europe is low but positive and moving away from a recession. In the US, growth has been above potential for some time and is now slowing down.
To be clear, we are not suggesting the US macro environment is bad. But we do think that for fixed income investors, conditions look more favourable in Europe at this juncture.
Corporate bond spreads have tightened significantly over the last few quarters across the globe as fears of a hard landing have faded. However, just as with macro conditions, there has been divergence between geographies.
Following steady contraction over recent months, US corporate bond spreads are now almost as slim as we have seen since the global financial crisis; as of the end of May, US investment grade (IG) and high yield (HY) spreads sat at 88bp and 338bp, not far from their respective post-2008 tights of 82bp an 316bp achieved in mid-2021. 1 In other words, investors are being paid relatively little to hold corporate risk over US Treasuries.
European spreads by contrast have not tightened as aggressively. The corresponding spreads on European IG and HY bonds at the end of May were 108bp and 351bp, some distance from their respective post-2008 tights of 72bp and 235bp achieved in late 2017 and early 2018. 2
As Chart 1 shows, the yield opportunity in European and US high yield bonds looks virtually identical at the headline level. However, adjusting for the duration and rating of the respective indices for a true comparison, European HY offers a significant premium.
Source: ICE Indices, 12 June 2024. Past performance is not a reliable indicator of current or future performance. Included for illustrative and discussion purposes. It is not possible to invest directly into an index and they will not be actively managed. These views represent the opinions of TwentyFour as at June 2024, they may change and may have already been acted upon, and do not constitute investment advice or a personal recommendation. They may also not be shared by other members of the Vontobel Group.
We also see specific relative value opportunities in European financials and CLOs versus their US equivalents.
The European banking sector continues to exhibit improving credit quality, as evidenced by its consistently strong upgrade/downgrade ratio (see Chart 2).
Source: Bloomberg, Moody’s, data as at 12 June 2024.
Profitability levels for European banks are the highest in years, thanks to margin expansion driven by successive rate increases. Capital levels are way above regulators’ requirements, non-performing loans (NPLs) remain low and their exposure to the problematic commercial real estate sector is generally far lower than it is at US banks.
Given these robust fundamentals, it is worth noting the spread premium that European Additional Tier 1 bonds (AT1s) offer over US banks’ preference shares (see Chart 3).
Source: TwentyFour, Bloomberg, data as at 12 June 2024. These views represent the opinions of TwentyFour as at June 2024, they may change and may have already been acted upon, and do not constitute investment advice or a personal recommendation. They may also not be shared by other members of the Vontobel Group. Included for illustrative and discussion purposes. No assumption should be made as to the profitability or performance of any issuer identified or security associated with them. Further, views are subject to change and the information provided should not be viewed as a certainty.
Similar to financials, our preference for European over US CLOs is driven by a combination of fundamentals and value.
From a fundamentals perspective, European CLOs have several advantages over their US counterparts. European CLO managers are required to retain a meaningful portion of the risk in every deal they sell to investors (US managers are not required to keep “skin in the game”), and loan documentation in the US is generally regarded to be weaker. European CLOs typically have greater exposure to single-B rated loans, but US deals tend to have more CCC rated exposure. As a result, European CLOs saw fewer downgrades during the Covid-19 crisis and also experienced fewer losses during the global financial crisis.
Looking across the CLO capital stack today, we see attractive valuations in Europe both on a yield and a spread basis (see Chart 4). This is not to say that we don’t see opportunities in the US CLO space, but given we anticipate income being the main driver of total returns in the coming quarters, we favour European CLOs over US equivalents.
Source: Citi Velocity, ICE Indices, Bloomberg, data as at 12 June 2024. These views represent the opinions of TwentyFour as at June 2024, they may change and may have already been acted upon, and do not constitute investment advice or a personal recommendation. Included for illustrative and discussion purposes. It is not possible to invest directly into an index and they will not be actively managed. Yield for floating rate assets calculated by adding the credit spread to the relevant swap-rate. It is not possible to invest directly in an index and they will not be actively managed.
Given our base case scenario of growth improving from the lows in Europe and falling to more sustainable levels in the US (with no recession), we think spread products are likely to continue to outperform government bonds.
We do believe government bonds look reasonable value at current yields. If inflation continues its (delayed) fall to target, allowing central banks to cut rates, then at current levels government bonds are likely to deliver more or less their yield, albeit with some volatility along the way. If we are right about inflation coming down, then the chances of sustained mark-to-market losses in in 10-year US Treasuries, for example, are relatively small. In other words, government bonds look to be an inexpensive insurance policy against our non-base case scenario of a hard landing.
However, constructing a portfolio expecting a large rally in government bonds due to central banks cutting rates is unlikely to be a winning strategy, given the lack of certainty investors can have around monetary policy. We think income will be the largest component of total returns for the next few quarters.
As a result, we believe looking across geographies for the best value income is the right approach. And at this point, we see better relative value opportunities in European bonds than we do in the US.
1. BofA ICE Indices, TwentyFour, data as at 31 May 2024.
2. BofA ICE Indices, TwentyFour, data as at 31 May 2024.
