Written by Rufaro Chiriseri, Head of Fixed Income for the British Isles at RBC Wealth Management
With the regional economy struggling, the reforms agenda has been given new impetus. Recommendations to improve the effectiveness of the single market are due in the spring; it will be up to the new European Parliament, which will be elected midyear, to implement them. For fixed income, our bias is to add to sovereign fixed income positions and increase duration given the weak economic environment.
Opportunities exist beyond the cloudy macroeconomic outlook.
The European Central Bank (ECB) thinks that, if interest rates are maintained at 4% for a long enough time, inflation will be brought back to target. Though ECB President Christine Lagarde has labelled rate cut discussions as “premature,” the market is pricing in about 100 basis points of policy loosening commencing next March through December 2024.
Our base case is no cuts in H1 2024. The risk to our view is an uptick in inflation from rising energy prices, which could prompt the ECB to hold rates at 4% for longer. Alternatively, a further deterioration in economic activity could ultimately cool inflation faster than the central bank expects, bringing rate cuts into view sooner that we anticipate.
The risk of a recession in the eurozone has increased, in our view, with economic activity data pointing to stagnation. All measures across manufacturing and services have fallen further into contraction territory. RBC forecasts 2024 growth in the region to teeter on the edge of recession and to reach a paltry 0.1% year-over-year growth.
The ECB’s process of reducing assets on its balance sheet, also known as quantitative tightening (QT) of the Asset Purchase Programme (APP) is underway with no reinvestments of maturities, while reinvestments from the Pandemic Emergency Purchase Programme (PEPP) are set to continue through the end of 2024. Under the scenario of PEPP reinvestments continuing, we expect the demand for European government bonds to absorb supply next year given the attractive level of yields.
The high allocations in Italian and Spanish bonds within the purchase programme have supported spreads thus far. However, Italian bond spreads have widened recently against German Bunds due to an increase in QT, the growing risk of a rating agency downgrade, and fiscal deficit concerns. The International Monetary Fund forecasts debt will be around 140% of GDP in 2028—worsening by more than 8% from its prior forecast. The European Union’s fiscal deficit rules are supposed to be back in force in January 2024, and discussions about reforming these rules are ongoing. The return of fiscal rules, which had been suspended since the onset of COVID-19, could increase bond volatility in nations that are close to or above the fiscal limits. Against this backdrop, we prefer Greece over Italy for lower-rated nations, and we balance the allocations across core nations such as Germany, Belgium, and Netherlands. We are biased to add to sovereign positions and duration as the economic outlook is set to deteriorate further, thus benefiting longer duration and sovereign positions.
Credit markets have been resilient despite QT and the ECB holding nearly 33% of the eligible corporate bond universe. However, if the pace of corporate bond reduction increases, spreads could widen. On a one-year basis, credit spreads look wider, but nearer fair value over a five-year period. While spreads look compelling, we are loath to chase these levels as higher financing costs as well as lower corporate earnings are impairing corporates’ fundamentals.
Thus, we remain cautions and maintain our up-in-quality bias, preferring investment-grade over high-yield credit for now. The yield compensation for interest rate risk in high-yield versus investment-grade debt has narrowed meaningfully and is close to decade lows. Therefore, on a risk-reward basis, we favour investment-grade bonds given the recession risks. Yet, we acknowledge there will likely be an opportunity to allocate to high yield when spreads meaningfully widen.
We believe the theme for 2024 is to remain selective and defensive and focus on issuer fundamentals. In particular, we favour non-cyclical over cyclical issuers, senior ranking bonds issued by banks, the Utilities sector, and Telecommunication Services industry.