Recession remains unlikely in the euro zone

April saw positive performances for risky markets, with equities and convertible bonds outperforming, followed by high yield. Government bonds underperformed across most major markets except Japan. We also saw a recovery of subordinated and CoCo bonds to the detriment of more senior issues.


Euro zone: disinflationary trend is confirmed, but we are monitoring rating risk closely

In the euro zone, we continue to expect moderate growth and a deposit rate peaking at 3.75% as the most likely scenario. That said, the possibility of stickier than expected inflation leading to a higher terminal rate and lower growth should not be discounted either. In our view, a full-blown recession remains unlikely.

The ECB’s latest messaging has been nuanced. It continued to insist that inflation remains too high, but also pointed out that the strength and time lag of transmission of its monetary policy decisions are uncertain. The next Eurosystem staff macroeconomic projections will be closely scrutinised for clues as to the inflection of the next decisions. In terms of its commitment to the phasing out of non-standard monetary policy measures, however, the ECB remains resolutely hawkish. It announced that the APP programme would be phased out from July, earlier than expected.

From a top-down perspective, therefore, our overall view on euro duration remains largely unchanged, but we are reinforcing our 10-30 steepener trade as we approach the likely end of the tightening cycle. On a per-issuer basis, we have strengthened our underweight conviction on France. We already held this underweight bias vs an overweight on Austria; we are now implementing our increased underweight vs. Austria and Finland, and therefore continue to remain neutral on core/semi-core issuers. Following the recent downgrade of France by Fitch, rating risk in the form of a downgrade by one or both of the other major rating agencies is very real. More fundamentally, we share many of the observations made by Fitch. In the short and medium term, the supply picture is likely to put upwards pressure on French rates. Longer term, the fiscal dynamics and deficit picture are challenging.

On non-core countries, we are now taking a slight underweight position via Portugal. While the country’s fundamentals remain convincing, following a positive performance, spreads vs. core countries have come down considerably and valuations appear rich. The earlier-than-expected phaseout of the APP programme should also put disproportionate pressure on Portuguese rates. Two rating reviews are also expected to be conducted on Italy, by Fitch and Moody’s. There remains some risk of a downgrade – that said, we do not fundamentally hold a negative view on non-core issuers overall. In our view, the Italian government is unlikely to implement fiscal decisions that will frighten markets. Spanish rates appear fairly valued.


Positive on New Zealand and UK rates

We remain positive on UK rates based on what we view as structural weaknesses in the country’s economy. Inflation remains high, but we see signs of a turnaround and expect the BOE will not hesitate to pivot rather swiftly. Conversely, in New Zealand, we see an extremely hawkish central bank. Why do we think this is positive for NZD rates? In our view, the RBNZ will have no qualms about pushing the country into a true recession to control inflation, and indeed we think this is the likely outcome. We don’t see the markets pricing this risk with the attendant pivot from the central bank that would follow.


We remain constructive on EM local currency rates and FX

Most emerging markets had a head start on rate hikes vs. the Fed and the ECB, and did not need to play catch-up. With the Fed now having reached a pause and a clear disinflationary trend (with many emerging economies now having lower inflation than most developed countries), the stars are aligned for a pivot from many central banks. We also believe that the strong recent performance could be a driver of flows into the asset class, improving supply and demand dynamics. In particular, we like Mexico, Brazil, Indonesia and the Czech Republic.


EUR investment grade remains attractive, prudent on real estate and low-rated companies

We remained positive on euro Investment Grade. Yields are still attractive from a historical perspective and they offer good carry in the event of economic deceleration. Fundamentally, the latest earnings announcements of corporate issuers have confirmed our expectations, but issuer differentiation came under scrutiny as dispersion is increasing. Some firms announced strong Q1 results, while others issued profit warnings. In summary, we see that large and mega caps have largely succeeded in passing on higher costs to customers. Dispersion has been especially marked among high yield issuers, with European issuers generally coming in stronger than their American counterparts.

One sector of the credit market in particular has come under strong pressure from rising interest rates: real estate. Some issuers have already seen downgrades, and funding in the US is also likely to be squeezed as a result of pressures on regional banks. Much of the business model has been fundamentally called into question with interest rates at the levels at which they now stand; the cost of debt is now higher than expected returns on assets. Globally, 30% of real estate debt will need to be refinanced this year – and certain firms will likely be unable to do so and will need to sell assets at unfavourable terms. Interest coverage ratios are becoming tight, and revaluations of assets could trigger covenant breaches. Further downgrades are certainly not off the table. We will pay close attention to developments in the space, notably to potential ramifications on the banking sector: certain German banks in particular have a high degree of exposure to the space on their loan books. A wave of downgrades in real estate could also prompt us to become more negative on high yield as these firms exit the investment grade universe.

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