February was marked by a strong investor preference for risky assets, with equities on both sides of the Atlantic performing well. Conversely, government bonds underperformed, with yields in both eurozone government bonds (+25 bps for the German 10Y) and US Treasuries (+34 bps for the US 10Y) rising substantially, leading to a negative performance. Thanks to higher carry and spread compression, non-core EUR government issuers and credit outperformed – with EUR HY even delivering a marginally positive performance. Indeed, somewhat sticky inflation prints and continued strong economic data from the US has led traders to substantially curtail their expectations regarding central bank cuts – which had arguably significantly overshot well beyond our own and most economists’ expectations.
For the US, our central economic scenario continues to be that of a “soft landing”, with slowing but still clearly positive GDP growth and inflation coming close to, but remaining above, 2%. We see the eurozone narrowly escaping recession, and accordingly more pronounced disinflation – with the ECB probably achieving its target.
The selloffs we saw on a number of rates markets globally lead us to upgrade our view of rates generally, and we are now overweight on most major markets except Japan. We are also upgrading our views of select spread asset classes, notably EUR IG and HC EMD, based on a benign macro backdrop and fundamentals that are holding up.
Long on US duration after a better entry point
After having taking profit on our long duration exposure at the end of 2023 following the strong rates rally, we were awaiting a retracement for a more attractive entry point as we move further into the monetary cycle. Following the selloff in the first two months of the year, we decided to reinitiate a small long preference in US rates.
We do not expect the upside surprises in inflation data to continue, with the likes of owner’s equivalent rent normalising somewhat in the coming months. Furthermore, while still robust, the labour market continues to show signs of returning to normal, vacancies are continuing to fall and wage growth is still set to slow to around 3.5%, consistent with the Fed’s 2% target for inflation. With the market pricing for 2024 cuts now aligned with the Fed’s dot plot, we believe the market is more realistic about Fed actions this year, which still appear to be in the FOMC’s plans despite early-year data surprises, with Jerome Powell maintaining the stance that rate cuts will come “soon”. With the market likely to oscillate between current cut pricing and the alternative of pushing central banks to be more aggressive in their cutting cycles, we think that current levels offer an attractive re-entry to duration positions.
The eurozone and the UK: With similar dynamics, we go long on both rates markets
In the eurozone, similarly, the decelerating inflation trend remains firmly in place. On the rise of rates that we witnessed during February, we decided to move to a positive view on EUR duration overall, implemented via the 10Y tenor. As the German 10Y broke through 2.3% following upside surprises in US data, we saw a readjustment in expectations regarding central bank policy. We also see positive signals from our fair value models, as inflation trends continue to decelerate together with a stagnating eurozone economy. The ECB continues to very much be in “data dependent” mode and hesitant about giving explicit guidance on the timing of rate cuts. In terms of technicals, the negative effect of heavy supply frontloading is now also receding. Finally, background risk related to US regional banks and commercial property could somewhat temper the extremely “risk-on” mood of markets year-to-date.
In terms of countries, we continue to hold an underweight on France vs. Austria. We also retain our underweight conviction on Belgium due to anticipated difficulties around government formation following elections later this year. We implement this trade vs. Portugal. Portugal was upgraded whilst being kept on a positive outlook, supporting relative performance. We don’t see substantial risks to our thesis arising from the recent election, and fiscal strength is likely to continue in our view.
We also like central and eastern European (CEE) issuers, both within (Croatia, Slovakia, Slovenia) and outside (Romania, Bulgaria) the eurozone. In particular, we see Bulgaria as exhibiting the political will to be on track to join the eurozone in 2025 or 2026, which would further support spread performance.
The UK economy is clearly still very much anchored in Europe, with weak inflation like the eurozone and a similar inflation trajectory. In light of this, we see market pricing of only two cuts from the BOE as probably not sufficiently aggressive. With UK inflation set to fall markedly in the coming months, we see a first cut in the base rate coming at around the same time as those of the ECB and the Fed. We are also somewhat reassured following the recent vote on the budget, the last one before the next general election, with the risk of pre-election fiscal largesse now subsided. This has prompted us to re-introduce our long position on gilts.
In Norway, the macro backdrop remains robust, but we believe inflation could be starting to slow more than expected. We expect wage negotiation outcomes to come in below projections. Additionally, NOK strength should also help do some of the disinflationary work with less importance on interest rates. Current market pricing for NOK rate cuts are more restrictive than for the country’s peers, especially the eurozone – and we expect a convergence in this regard. We are therefore also initiating a long position on Norwegian rates.
Emerging markets: With a benign backdrop, we are now constructive on all sub-segments
The general EM backdrop has been improving with easing global financial conditions, the FED expected to begin cutting rates this year and Chinese data stabilising albeit at lower than pre-Covid levels. Although spread levels vs. US Treasuries remain tight, we are upgrading our view on hard currency EM sovereigns from neutral to positive. While yield pickup is very moderate in the higher-rated segments of the market, absolute yields remain attractive. Importantly, we see little reason – given the macro backdrop – to be concerned about fundamentals at these levels. We also note that whilst premiums vs. Treasuries are tight, the picture is largely in line with other risk assets.
We are, however, downgrading Chinese rates on a standalone basis. With low investor expectations around Chinese growth already, in our view, priced into rates, we do not see CNY rates as attractive given the already large yield differential to treasuries.
Currency markets: We close our trade in the Antipodes and go short on CHF
We took profit on our AUD/NZD trade as the trade moved in our direction, and we believe the cross has much further to go. We continue to retain conviction in our long NOK vs. SEK trade, based on central bank purchases and the fundamental undervaluation of Norway’s currency.
We introduced a short position on the Swiss franc. The currency appears expensive after its 2023 rally, and momentum had been building in the market towards a selloff in the context of a very “risk-on” mood. Whilst in the 2022-2023 period, a strong franc was likely welcomed by the SNB as a buffer against inflation, in the context of the global disinflationary trend, that view has shifted in the central bank – with chairman Thomas Jordan indeed noting the strong currency as a factor hurting companies.
A more positive outlook on EUR IG credit based on a favourable macro context, a downgrade of convertibles based on our equity outlook
In a theme that we see playing out among most risky asset classes, spreads for Investment Grade EUR corporate credit are tight compared to government bonds. Nonetheless, we see little reason for concern from a fundamentals perspective, and ratings drift continues to be positive. Our upgrade comes against a backdrop of a tightening supply picture, with firms being in the comfortable position of often not needing to tap the bonds markets to refinance themselves. Frothy equity valuations and banks still very willing to extend loans give corporate issuers ample flexibility. We believe this will provide protection against any substantial spread widenings.
At the same time, we are downgrading our view from neutral to slightly negative on the convertible market on aggregate, based on our tactical view of the equity market: investor sentiment, investor positioning, a strong technical level and an absence of positive catalysts, unlike last month with the earnings season as a source of possible support.
Our view on US credit (both IG and HY) remains that the segment is unattractive based on valuations, especially for EUR-hedged investors.