The shift from interest rate hikes to cuts should significantly benefit European fixed income, as high yields present considerable opportunities for both income and capital gains in the coming years.
End of an era?
The ECB recently finished its fastest and largest hiking cycle since its formation in 1998, leaving the deposit rate at 4%. Historically, interest rate cuts support bond performance, driving yields lower and prices higher.
Bond prices and yields behave like a seesaw: when yields fall, prices rise. Since 1999, the Bloomberg Euro Aggregate Index has returned over 5% on average in the 12 months following ECB rate reductions. This includes a favourable distribution, as the top 75th percentile of return periods was over 8% and the bottom 25th percentile return of around 2%.
The fundamental outlook for European fixed income is based on three key drivers: growth, inflation and the ECB’s policy stance.
On the growth front, the European landscape remains relatively muted. Despite signs of improvement, GDP is likely to come in under 1% for 2024, trailing the last seven-year average. Nevertheless, from a corporate credit perspective, the ability to repay debt remains strong, with stable earnings trends expected.
We’ve also seen a material improvement in the European inflationary dynamics this year, with year-on-year core inflation in May rising by 2.9% versus 5.3% in 2023 (and while May’s numbers surprised slightly to the upside, there were always going to be bumps along the way). That said, we’re far from declaring victory. The pace of disinflation has slowed relative to the second half of 2023. This, combined with still-strong wage inflation and unfavourable energy base effects, is likely to keep headline inflation above the ECB’s 2% target for the remainder of 2024.
What does this mean?
ECB officials remain data-dependent and will want to see services inflation below 3.5% in the second half of 2024. This would be in line with their March forecasts and justify the projected 75 basis points (bps) of cuts for the year. For a more aggressive path, we’d likely need an acceleration of disinflationary trends driving inflation below the ECB’s 2% target. However, this scenario is not yet supported by the data and is further complicated by delayed start to the cutting cycle in US.
Implications for EU fixed income?
European bond yields have spent much of the year adjusting higher, as stronger US growth and inflation have driven a shift in market pricing. Expectations of a deep US interest rate-cutting cycle have been replaced with a shallower cycle. We see opportunities here, as divergences increase with different growth, inflation and policy paths in Europe than elsewhere.
Where to focus?
We find short-maturity investment-grade (IG) corporate and government bonds particularly appealing. High starting yields mean these investments can deliver strong total returns in most scenarios. Shorter-maturity bonds are likely to benefit from interest rate cuts, as the yield curve typically steepens following reductions. This results in shorter-maturity bond yields decreasing more than their longer-maturity counterparts, which is favourable for bond returns.
In the credit market, European IG corporate bonds present good value over the medium to long term. These assets have historically performed well in the 12 months following a central bank pause, as investors seek credit with attractive yields. All-in yields are attractive, with IG corporate bond yields offering a premium of 50bps above the Stoxx Europe 600 Equity Index dividend yield.
Credit spreads in investment grade can no longer be characterised as ‘cheap’ considering the rally over the last year. However, European IG spreads are still 10-20bps cheaper relative to the US dollar market, based on historical relationships. We think spreads in Europe have not fully priced out the risk premium established from the ongoing Russia/Ukraine war and resultant energy concerns. Our preferred segment within credit is short-dated corporate bonds with 1-5 year maturities. If government bond yields remain relatively unchanged, investors can benefit from an additional 90bps of yield. If yields fall, this asset class will generate strong returns. If growth weakens and spreads widen, the decrease in government bond yields should offset most, if not all, capital losses. This will ultimately lead to positive returns when considering the starting yield.
Meanwhile, high-yield debt offers relatively little additional premium for the risk taken, which leaves us somewhat cautious. Nonetheless, a lot of this reflects very favourable technical dynamics. Investors are cautiously positioned (high cash balances), there’s been little new bond issuance (supply) and we’ve seen several upgrades to investment grade (notably Ford). As a result, the size of the euro high-yield market has shrunk by 15% over the last two years.
Final thoughts…
As expected, the ECB started cutting rates in June. This creates opportunities for diligent fixed-income investors, offering both the prospect of income and capital gains. The key is to stay vigilant and watch out for shifts in the data.