Where next for Euro credit?

There have been multiple dramatic narratives in Euro credit this year, and investors have barely had time to catch their breath.

Regional banking stress in the US was echoed in the collapse of Credit Suisse in Europe. This offered a brutal demonstration that regardless of strong balance sheets and profits, in the current rate environment banks are vulnerable to rapid deposit outflows, accelerated by digital banking and social media driving run-like behaviour among depositors. It also showed us that banks are highly correlated, with the whole sector coming under pressure.

However, what was remarkable was how the overall yield on credit proved to be quite resilient. While government bond yields were down on the back of this turbulence, spreads widened, and the overall yield of investment grade was stable over this period.

Investors could be forgiven for now asking if these events represent a return to ‘normal’.

Hello decorrelation, my old friend

We all know 2022 saw fixed income and equities falling in tandem, in stark contrast to the negative correlation they usually offer.

So, in at least one sense, normality is returning: risk assets fell on the back of the banking stress, as did yields – which of course meant that bond prices rallied.

It’s not quite time to pop any champagne, however: 2022 started with such low yields that in our view they didn’t offer any real buffer; now, yields of 4% or so mean there is some room for them to fall as prices go up.

Echoes of history

We must place all of this in the context of Europe facing one of the most widely predicted recessions any of us can remember, and consider what we might learn from past recessions.

The first thing we must remember is that every crisis is different. Our modelling suggests that spreads versus government bonds are now somewhere around their average for the period since 2006 (i.e. including the global financial crisis). But if we compare the current moment to the European sovereign debt crisis or even the onset of COVID-19, we are in the bottom end of that range – so I would say markets are yet to fully price in a recession, or are anticipating only a very shallow one.

Quality counts

This puts the focus on company fundamentals. There are concerns around the financial sector, in particular its apparently growing degree of correlation. Leaving that sector to one side, we see that most companies appear to have used the cheap liquidity they were offered during the pandemic to – at the very least – extend the maturity profile of their debt. If we are heading into a recession, many would appear to be heading into one in a decent position.

That said, we believe the market doesn’t discriminate enough between the better names and the not-so-good names. We like firms that are less cyclical and higher quality.

With lending conditions already stringent and likely to become more so, and our economists forecasting a European recession in the second half of the year, we feel cyclical companies are more vulnerable at present – especially those at the lower end of the rating spectrum.

Valuations are finely balanced

Turning to valuations, carry is at present quite substantial. In our view you are getting a decent reward for taking risk. But if spreads move into the 90^th percentile since 2006 – i.e. into a zone they have only entered for 10% of the past 17 years – then in our view you’re not properly rewarded at this point. This explains the cautious positioning we have adopted in all our portfolios.

A key variable will be the end of the European Central Bank (ECB)’s asset purchasing programme; in being limited to only partial reinvestments, it’s already come down substantially. This support is definitely going to eventually drop away whether or not the programme ends on schedule – but I think this is actually good news for active managers, as the ECB has been an indiscriminate buyer in terms of quality.

We would anticipate that once the programme is finally ended, there will be meaningful divergence between names based on quality, creating opportunities for savvy investors.