Recent moves in fixed income have been eye-watering, particularly in Europe where we have seen sovereign bond yields breaching quarter-century highs and wider spreads in some echelons of corporate credit. Pressure has also been bubbling under the hood; for example, in the past month we have seen the biggest weekly widening in Franco-German spreads since German reunification in 1990. As a result, broad European rates premia have moved to their highest positive “spread” to European equities since at least 2011, which is highly unusual. We believe it is also unlikely to last.
A Quarter-Century Pattern Has Broken
As risky assets, equities tend to demand a higher premium from investors relative to bonds, that tend to be less volatile. This is particularly the case in Europe, where high equity dividends and payouts have helped the relationship “stick” for a quarter of a century, barring brief spells during the European sovereign debt crisis and the 2020 pandemic. October’s moves in fixed income have delivered a clear break between these relative premia.
Our heuristic for equity-like European fixed income is long-dated sovereign bonds, with some corporate spread risk added on top. Equity earnings yields are now meaningfully below this fixed income proxy. And it is not just a sovereign story: the European earnings yield relative to the yield-to-worst on BBB corporate credit spreads sits below the 20th percentile after the latest moves, ranges we last saw in the immediate aftermath of the GFC. Interestingly, European investment grade credit spreads have also moved closer to the 50th percentile (from the 20th percentile), moves not mirrored in similar U.S. corporate bond indices.
Why We Think the Gap Won’t Last
Both the European Central Bank and the Fed were more confident on growth in their September projections. Although we don’t expect priced rate hikes will ultimately be delivered in either, there is an important distinction: where we are more concerned about growth in Europe, we are more sanguine on U.S. inflation.
In Europe, downside risks to growth are judged to be mounting. A delivery of further anticipated interest rate hikes would see overnight rates caught between 3 – 3.25% out for five years, a dramatic shift from a year ago when policy was expected to ease toward 1.75% and hold steady up to 2%. Absent the offsetting positive of AI-related investment that benefits the U.S., European growth looks poised to be weaker than anticipated, in keeping with recent history.
In addition, pressure on bond markets has brought European fragmentation risks into sharp focus; when the effective interest rate exceeds nominal growth, a primary surplus is needed to stabilize debt/GDP. Insofar as bond yields typically peak once central banks are done hiking, for the ECB, holding back from raising interest rates could be more impactful than activating its Transmission Protection Instrument (a bond purchase mechanism aimed at controlling fragmenting spreads across the eurozone).
By contrast, in the U.S., core inflation is drifting lower even as growth is proving to be fairly robust. Higher real rates may also not warrant a strong monetary response if indeed AI is a factor of production, as Fed Chair Kevin Warsh suggested in his Jackson Hole speech in August.
A Forced Error?
A closer look at relative rates moves suggests markets appreciate this macro dispersion. More than 90% of year-to-date moves in Treasuries is driven by real yields, typically linked with growth, versus nearly 80% in German bunds driven by breakevens or inflation concerns. Looking across asset classes, our principal component analysis frameworks for the U.S. suggest that markets more broadly have shifted toward pricing in stronger growth and lighter inflation.
Notably, European economies are managed to a different policy objective compared to the U.S. The ECB’s singular focus on headline inflation contrasts with the Fed’s dual objective and more flexible targeting approach. Policy rates that move higher and stay higher for longer could be seen as a “forced error” in that context, with the ECB Governing Council also seeking to avoid a repeat of the 2021 – 22 policy mistake of not tightening sufficiently.
Our Positioning
Year-to-date markets have barbelled: growthier assets like equities and commodities are performing smartly, with a more challenged setup for core fixed income assets. In Europe, our expectations suggest a prospective turn, with fixed income judged to be relatively more attractive than equities within asset allocation. European fixed income premia have charged higher since our last grid was published, and look more attractive over the medium term. By contrast, European equities may be held back by cyclicality, high concentration risk (skewed toward autos and banks) and somewhat fuller valuations in their own context versus global peers, even after recent derating. Consensus expectations of 23% year-on-year EPS growth in the second half, and continued positive growth in 2027, may prove to be too optimistic. In the U.S. and especially Japan, we expect equities to outperform regional bonds.
What to Watch For
Tuesday 10/20:
- Eurozone: Economic Sentiment
- U.K.: Average Earnings & Unemployment
- U.S.: Atlanta Fed GDPNow
Wednesday 10/21:
- Canada: Consumer Price Index
- U.K.: Consumer Price Index
Thursday 10/22:
- Japan: Consumer Price Index
- U.S.: Initial Jobless Claims
Friday 10/23:
- Eurozone: Composite Purchasing Managers’ Index
- U.K.: Retail Sales
- U.K.: Composite Purchasing Managers’ Index
- U.S.: Composite Purchasing Managers’ Index
- U.S.: Michigan Consumer Sentiment
