Although still elevated, inflation is on a declining path

First, let’s look at the economy. At the time of writing, revised numbers showed the eurozone had fallen into mild recession. GDP for the first three-months of 2023 shrank 0.1%, mirroring Q4 2022’s performance. High interest rates and elevated energy prices have weighed on consumer spending.

Despite the challenging backdrop, the European Central Bank (ECB) increased interest rates by 0.25 percentage points to 3.25% in May. Fighting inflation remains front and centre for the ECB. The headline rate rose slightly from 6.9% in March to 7% in April. However, importantly, the bigger picture is that inflation is still on a declining path, down from a peak of 10.6% in October. We expect it to decline further by the end of the year. As such, we believe we are close to the peak in ECB rates, with just one or two more hikes likely this year.

Is the banking sector fallout contained?

Then there’s the banking sector. Since the collapse of SVB and Credit Suisse, commercial banks have tightened lending standards. This reflects higher interest rates, as well as concerns about non-performing loans in the face of the challenging economic backdrop. Implications of the Credit Suisse AT1 writedowns could also have wider implications for the AT1 asset class. The cause of recent bank failures has been liquidity, not capital. This could result in regulators reconsidering assumptions used in calculating liquidity ratios.

Despite these factors, we think the European banking sector remains in relatively good shape. The problems at Credit Suisse were largely idiosyncratic. It had set out a viable restructuring plan last year, and we thought the market would give the bank time to deliver. However, management lost control after a renewed flight of deposits following events in the US. Misquoted comments from Credit Suisse’s largest shareholder exacerbated matters.

As for the wider European banking sector, balance sheets are strong, while management teams retain a bond-friendly approach. Fee income remains robust thanks to buoyant market-based revenues. Many lenders have also boosted profits by releasing reserves. The recent sell-off was therefore a buying opportunity for selective names.

What does China’s reopening mean for Europe?

The reopening of China’s economy is a boon for Europe. The continent’s corporate sector is exposed to China through the trade and tourism channels. Taking imports and exports as a total, China is the EU’s biggest trading partner (16% of the total trade activity in 2021). China’s post-zero-Covid growth is likely to be consumption-led, which should help European goods exports.

On the travel side, China’s increasingly important role as a travel services ‘importer’ is often underappreciated. Outbound travel rules have also been eased, with Europe expected to see the return of Chinese tourists. Combining all channels, we think a 1% increase in China’s real GDP growth should translate into an uplift of 0.1%-0.2% in European growth.

Valuations and yields

Euro IG credit valuations are still attractive. The index level ‘all-in’ yields remain above 4%. This is the result of significantly higher bund yields and credit spreads above long-term averages (although we are seeing a bit more cushion in the latter). To put valuations in perspective, the ‘all-in’ yield for euro IG corporates was below 0.2% as recently as August 2021 – they are now close to 10-year highs.

Supportive euro hedging costs

One additional point to note, particularly for US and US-based currency investors, is significantly reduced euro hedging costs. In a reversal of the norm of recent years, the market is now offering a higher currency-hedged yield (about 100 basis points) than the yield for US dollar IG corporate bonds.

Final thoughts…

The last few months have been challenging. However, we remain positive on the outlook for euro IG credit. Inflation, while elevated, is still on a broadly downward trajectory and we expect to decline further in coming months. The ECB is therefore likely nearing the end of its hiking cycle. Meanwhile, the fallout from recent banking turmoil has been limited. The valuation picture is also encouraging, with ‘all-in’ yields above 4%. We believe this makes it an ideal time to selectively increase exposure to high-grade European credits.