At first glance, rising US rates make USD-denominated bonds seem like a juicy plum for yield-starved European investors. But, allowing for the increased cost of hedging currency risk, US bonds’ yield advantage has now been cancelled out and will stay close to zero or negative over the coming year.
1) European Assets Increasingly Attractive
The main driver of hedging costs is the interest-rate differential between short-term rates in US dollars versus euros. Right now, US rates are already at their highest versus European rates since spring 2007. But on our current forecasts the gap is only going to grow, rising from 2.5% as of January 9th 2019 to 3.0% by the end of 2019. That’s because the European Central Bank (ECB) will be very slow to raise rates, while the US Federal Reserve will likely continue to tighten policy through 2019, with two more quarter-point hikes probably still in front of us.
That suggests European assets will continue to look attractive on a currency-hedged basis versus the US.
2) Europe’s Fundamentals (and ECB) Still Supportive
Eurozone growth moderated in 2018, following a strong 2017. Although trade frictions are impacting business and world trade is slowing, we expect the eurozone to continue to grow, although not at an above-trend pace, as it once did.
Meanwhile, we believe that the ECB will manage their tightening policy cautiously, to avoid derailing eurozone economies. Now that they have ended their asset purchases, based on the Fed’s example the ECB will likely wait a few years before beginning to unwind its balance sheet. And we don’t expect the ECB to actually raise rates before the end of 2019.
3) European Political Risk—Lower than Feared
First came fears of a “Grexit”, then Brexit became a reality, and now it’s Italy’s populist government that’s got market participants nervous.
But a lot has happened since the Grexit crisis of 2011—all of it encouraging for those who wish to invest in European debt. The ECB now has several different ways to pump liquidity into markets during difficult times, including buying a troubled country’s sovereign bonds (outright monetary transactions), implementing a broader bond-buying programme (quantitative easing) or lending low-interest cash to a nation’s banks (long-term refinancing operations).
The risk of financial contagion is also much lower than it was during the Greek crisis, as European banks have mostly reduced their exposure to Italy to manageable levels. Non-performing loans (NPLs) have fallen significantly across the European banking sector and, while Italy’s banks still carry a relatively high NPL exposure, this has fallen considerably, from 16.8% as of December 2015 down to 9.7% as of June 2018. So, while political uncertainty in Italy will continue to be a source of volatility, particularly for French and Italian banks, the underlying strength of the European banking system has been rising.
4) Time to Come Home… but How?
Fixed-income investors who follow a traditional aggregate benchmark may find themselves exposed to far more duration risk than we feel is prudent, considering that even modest rate rises could wipe out a full year’s interest.
So we think it’s important to balance interest-rate and credit risk with a mix of government, high-yield and investment-grade bonds. For now, we would keep duration risk low and lean selectively on the credit side to benefit from continued growth and low rates in Europe.
For instance, in the banking sector, the fundamentals are strong and valuations are attractive, which compensates for potentially higher volatility. In European high yield, selected credits offer attractive yields relative to US equivalents, and are supported by continued de-leveraging and positive technical factors, including limited supply; expected default rates are low too.
European investment-grade and high-yield spreads are significantly wider than they were at the start of 2017, and are already being priced for quite a cautious outlook and a substantial slowdown of European growth.* Meanwhile the European economy is still growing, albeit at a slower pace, while the financial system is cleaning itself up and monetary policy is turning. It’s a time of great opportunity and great change. For investors who do their homework and select credits carefully, we think it’s a good time to come home.
*Option-adjusted spreads as at 31st December 2018 compared to 31st December 2017 widened from 86 to 152 b.p. and from 277 to 494 b.p. for the Bloomberg Barclays Euro Aggregate Corporate Index and the Bloomberg Barclays Euro High Yield Index respectively.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams and are subject to revision over time. Source: AllianceBernstein.
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