Liberté, Egalité, Volatilité. As Benoit Anne, Managing Director – Investment Solutions Group of MFS Investment Management, explains in the following analysis looking at fixed income, volatility has risen substantially in the Eurozone over the past week, mainly as the result of the escalation of political risks in France.
While market volatility can feel painful at first, volatility can also be your friend. There are indeed two typical market patterns that can potentially benefit an active asset manager in the face of a risk aversion shock. The first pattern is about overshooting. When risk aversion rises due to a specific event risk, markets tend to overshoot and move towards pricing in the worst-case scenario. Looking at the French 10-year government bonds, the spread against the 10-year German Bunds now stands at 77bp, [1]a level we have not seen since 2012. The second pattern is about contagion: other asset classes or markets tend to come under pressure in tandem with the epicenter of the market crisis. In particular, the EUR IG Corp index has displayed some weakness as a sign of broader contagion. This should be no surprise as historically the correlation between IG Corp and European government bond returns has been quite elevated. France accounts for about 20% of the EUR IG index from a country exposure standpoint[2]. Within the 20%, 10.5% represents the weight of French financials, a sector that tends to be highly vulnerable to higher sovereign credit risk. In the case of the Eurozone mini-crisis, it may be too early to be thinking about buying opportunities, given the French parliamentary elections, the main source of political risk, have yet to take place. But the buying opportunities may be coming, and only an active asset manager who can analyze fair values and assess the relative strength of fundamentals across several single-names, sectors or countries may be able to take advantage of them. Finally, it is worth highlighting EUR duration has unsurprisingly done well in the face of the regional aversion shock, with 10-year Bunds yields compressing by some 30bp over the past week.
European fixed income assets back to long-term fair value. After the recent French-triggered slide in European fixed income assets, EUR credit is back to its long-term fair value. Our fixed income valuation score for EUR IG has indeed improved substantially, especially when looking at outright spread valuations. Specifically, EUR IG spreads now stand at 122bp, which is exactly where the 10-year spread average is. Likewise, the valuation for EUR HY has also strengthened. This contrasts sharply with the valuation backdrop for US credit, where spread valuations continue to look stretched. The US IG spread z-score, which is how we calculate our valuation score, currently stands at -1.07, pointing to significant richness. Spread valuation is of course a very important part of the valuation puzzle, but if you are a yield investor, it is important to keep in mind that total yields are going to be the more significant driver of expected returns. And these continue to look attractive across the board. With EUR IG yields at 3.76%, we believe overall that Euro fixed income is well positioned to deliver robust returns in the period ahead.[3]
The battle of the Supercores. Disinflation is still on track but progress in some places has been rather uneven. In the US, the beginning of the year was frustrating on that front, although some relief has been provided by the latest round of CPI data. Central bankers as well as global investors have been watching supercore service inflation—core services excluding housing, which is where the main line of resistance to disinflation lies. We did get some good inflation in the US last week, with the supercore service inflation index turning negative on month-on-month basis in May for the first time since 2021. However, it is still fair to say that, at 4.8%yoy, US supercore service inflation remains elevated. The picture looks considerably better in Europe, where supercore service inflation has now slowed all the way to 3.2% from its peak of 7.5% in mid-2023. With price stability playing such a big part of global central banks’ policy mandates, we believe that the wave of policy easing is upon us. We can still debate the when and the how much but overall, the macro environment has turned considerably more supportive of global fixed income.
[1] Bloomberg. difference between the 10-year France government bond yield and the 10-year Germany government bond yield. Data as of 14 June 2024.
[2] Bloomberg. Bloomberg Pan-European IG Credit index. Broken by country of risk and by sector. Data as of 14 June 2024.
[3] Bloomberg. Bloomberg Pan-European IG Credit index, option-adjusted spreads. Data as of 14 June 2024.
