European Bonds – Still More to Give

Benign inflation, a dovish central bank and healthy yields have helped boost the global attraction of European government bond and credit markets. With further monetary easing expected, European fixed income continues to look selectively compelling.

While the European Central Bank is expected to pause further interest rate cuts at its next meeting on July 24, we believe it is unlikely to be the end of easing this year, extending the supportive backdrop for European fixed income markets.

Indeed, we are expecting another two cuts to the current key rate of 2% in the second half, with the first potentially to come as early as September, amid near-term benign inflationary trends, a strong euro, subdued and uncertain economic growth prospects in Europe, and persistent global macro uncertainty.

The context for policy decision-making is made more complex by the U.S. administration’s tariff threat on European Union imports, and any potential retaliatory response by the European Commission. But even with this trade uncertainty, we expect the ECB to continue easing this year, with a second rate cut potentially in December.

Underpinning that call, which differs from the market’s expectation of only one cut by the end of the year, is our view that, ahead of any growth uplift from Germany’s €1 trillion five-year investment plan, we see some near-term weakness in economic activity in Europe, as well as lower wage increases and accelerated disinflation developing in the second half.

These factors combined form the basis of our view that the ECB is likely to continue to ease to the extent that we anticipate, an outcome that would bolster European government bond and credit markets.

Reasons to Be Constructive

Overall, our expectations for persistently stable inflation going forward should help European rates markets to broadly perform, potentially delivering healthy carry and rolldown returns over the near term.

This is supported by the fiscal stability of many European countries, including Germany, which, while it is spending heavily on growth, infrastructure and defense, is in a different financial situation to more fiscally challenged economies such as the U.S., Japan and the U.K.

Another key factor in our constructive outlook on European government bonds, and credit, is the relative attractiveness of absolute yields in the region. Tightening spread levels across rates and credit markets might not be to everyone’s taste, but the absolute yields on offer, for both European investors and on an FX-hedged basis for dollar-based investors, are attractive for portfolios.

This plays into the positive domestic and foreign demand dynamics supporting both markets.

Given the rate differential between Europe and the U.S., domestic European investors have been increasingly reallocating to euro-denominated assets from dollar assets this year, a trend similarly developing among institutional investors outside the euro area.

Anecdotally, there have been stories of asset allocation reviews and Europe is a likely beneficiary, forming part of a broader trend reversing the capital outflows the eurozone experienced during the negative rate environment.

Credit Where It's Due

Such rising demand for European assets is similarly benefiting the investment grade credit and high yield markets, which, over the medium term, look attractive even if a bout of market volatility pushes spreads wider in the short term.

There are good reasons for that: the depth of demand being able to absorb any volatility is important. This technical support, combined with attractive yields and solid financial fundamentals, has also been particularly supportive to European investment grade credit.

On the high yield side, the sector is benefiting from political initiatives and structural improvements, which have improved the ability and willingness of borrowers to repay investors.

In particular, a greater proportion of the high yield index, for example, is now secured and in shorter maturities. Credit rating quality has also generally improved, and company balance sheets are in better shape.

Staying at the Shorter End

While we continue to see attractive opportunities to invest across European rates and credit markets, we remain vigilant of some of the fiscal challenges faced by core European countries such as France and others.

We are also wary of long-dated government bonds in which yields have, for some countries, risen to fresh highs and may remain elevated; 30-year French yields, for instance, are trading at their highest since the euro crisis in 2011, and Germany’s are not far off those levels, either. The investor retraction from very long-dated debt is a global phenomenon, however, and one that will ultimately force governments to shorten their bond maturities and potentially help improve their fiscal stability.

These issues need to be watched closely, but in the near term, we remain broadly constructive in our outlook on the European bond markets due primarily to the supportive macro drivers and attractive all-in yields at the shorter end of the curve.