June saw some weak performances in European risky assets and spread products, with European equities, high yield and IG corporates posting negative returns. The month was marked by the repricing of terminal rates by many central banks in developed markets, with the BOE’s surprise 50 bps rate hike and the ECB’s commitment to continue with the rate hiking cycle. While spreads compressed over the month, the rate component was responsible for weak returns across assets, more acute on sovereign bonds, with Europe, the UK and the US all posting significantly negative performances, and Japan putting in a flat performance. As most of the feeble performance was driven by the rise in rates, high-quality credit bonds suffered the most, with AA-rated issuers posting the weakest returns. Local Currency Emerging Markets lost the previous month’s performance, while the hard currency segment has held up better over the past few weeks. Conversely, EUR convertibles performed fairly well.
US rates: slightly positive view
In the activity cycle, the US appears to be moving further into the repair stage. Overall macro figures show some resilience, but all the good news appears to be behind us, and we are seeing elements like the consumption cycle and production decelerating. The inflation cycle is moving lower and recent CPI numbers support this view, though core inflation is likely to remain sticky. On the monetary front, we expect the FED to remain alert, and there could be additional rate hikes, although we expect these to be limited. In this context, from a valuations perspective, the US rate market is quite attractive, considering that some slowdown is expected, and the impacts of the restrictive monetary policy are yet to be felt. In this context, we remain marginally positive on US rates, retaining a balanced short-term stance, while holding a positive strategic view.
Elsewhere, our UK framework points to a slightly positive stance. A material portion of the bad news appears to be behind us, and we should see the BOE start to regain its credibility on the inflation front. In spite of the short-term volatility in the space, we feel that a small long position is warranted (steepeners), particularly vs German rates.
Finally, we removed our long position on Norwegian vs. Swedish rates. Norwegian inflation continues to surprise to the upside, and core inflation (led by the food component) is putting a significant amount of pressure on the CB.
ECB to continue hawkish trend
We expect European growth to remain weak, though we do not expect the activity cycle to turn just yet. What is of a greater interest is the inflation cycle, as data from the ECB still points to high core inflation, indicating that the ECB has more work to do in terms of tighter monetary policy, with a potential impact on growth. We expect the ECB to implement two more hikes in July and September, and accelerate its balance sheet reduction programme. This could impact non-core markets more than core ones, despite the strong European Solidarity Programme. In terms of supply/demand, we see it as positive for non-core rates where long positioning is quite neutral, while we have short positions on core rates.
We decreased slightly our steepening bias on EU 10-30yr rates. While we continue to see value on the 10-30yr steepeners over the medium term, we have decided to tactically reduce our curve stance, as the ECB’s hawkishness has put back the end of the hiking cycle and triggered a flattening of the curve.
We maintain an underweight position on Portugal based on its expensive valuation, while we have increased our exposure to Slovakia via the primary market.
We maintain a preference for Austria over France. The trade continues to perform, from the highs seen in October 2022.
Positive on EUR IG credit, negative on EUR HY
We continue to see EUR IG as the most attractively-valued credit asset class. Spreads offer an interesting yield pick-up to rates, and we believe that company fundamentals should continue to hold up. Indeed, debt-to-capital ratios are strong and EBITDA margins are high. The financial sector (banks) not only benefits from good capital ratios, but over the course of the year has been exhibiting return-on-equity ratios of close to 10%, which is a 10-year high. Even though interest coverage could decline, and non-performing loans remains an issue that we need to monitor closely, we expect the high level of revenues to compensate adequately. We see a maturity wall over the next three years that could see close to 35% of debt needing to be reimbursed. However, IG issuers have been very active on the markets, with supply already over EUR 300 million in 2023 alone.
We are now more cautious on Euro High Yield. Spreads (at 380 bps on the ICE BofA Euro HY Non-Fin Index) are not discounting a material slowdown, and though fundamentals seem to be holding up (great number of rising stars), some cracks are appearing. The B and CCC segments are a lot less sturdy, and refinancing for these companies will come at a higher cost, considering the increase in rates and the dependence on floaters. We believe that default rates are still too low and the market seems to be contracting very rapidly (rising stars and lack of supply). Technicals are positive, but the aforementioned downsides are not fully offset by spreads and hence we hold a prudent view on these markets.
EMD LC favoured over EMD HC
Emerging Markets Hard Currency credit spreads are tight on the sovereign side, while high-yielding countries (mostly CCCs) have rallied significantly. Fed rate hike expectations are still present and a rise in core yields is not positive for Emerging Markets Hard Currency. Local Currency Emerging Markets retains our preference thanks to better valuations and positive real rates. Inflation levels continue to move lower in Emerging Markets countries and a number of central banks in the space are ready to ease their policies. The global macro environment is less supportive for Emerging Markets, as the rebound in China has fallen short of market expectations, particularly in manufacturing, while services have fared better. However, within the Local Currency Emerging Markets space (and aware of the fact that outflows continue on the Emerging Markets segment), we remain very selective, with higher duration on rates like Mexico, India and Indonesia. On the FX front, we favour LATAM currencies like BRL and MXN.