Euro Credit Outlook: Cautious on Weakening Fundamentals

1. What’s your view of the fundamentals and valuations in euro investment grade (IG) credit?

The fundamental picture in euro IG credit is notably weaker than US IG credit. On balance, we see a slight deteriorating trend in euro IG credit quality. Margins have come down significantly, driven by weakness in industrial and commodity sectors. On the positive side, leverage has remained relatively well behaved despite the weakening earnings trend. We think companies in more defensive sectors like telecommunications, healthcare and pharmaceuticals will continue to do fine. We also see potential opportunity within the infrastructure and construction and materials sectors, specifically in companies that have been benefiting from strong demand and improving credit profiles.

From a valuation standpoint, valuations look fair for current market and economic conditions, but we see limited upside in terms of spread tightening potential. Despite the difficult fundamental backdrop, we think euro IG credit could offer attractive carry if a soft landing actually comes to fruition. On the other hand, valuations could be significantly less attractive if global economies experience a renewed bout of inflation or slower growth than expected, in our view.

2. What do you think are the biggest wild cards in 2024?

For us, one of the biggest risks is what happens if market optimism turns. In our view, markets have largely priced in a soft landing, which may be too optimistic. What if the Federal Reserve (Fed) doesn’t cut rates in the next three to six months? We think a negative turn in market perception could push valuations significantly wider. For this reason, we’re very focused on economic data points not only in Europe, but globally, including the US and China.

Geopolitical unrest and elections, while very difficult to predict, are two other wild cards we’re keeping an eye on. With geopolitics, we’re watching for signs of escalation and potential impacts on oil prices. On the election front, 2024 will be a historic election year with 2 billion voters set to go to the polls in 50 countries.[i] We anticipate quite a bit of volatility as markets digest election probabilities and outcomes.

3. Are there any interesting technical themes you’re watching?

2023 was a strong year for euro IG credit inflows. According to JP Morgan, euro IG credit (excluding short duration) inflows amounted to about 6.7% of euro IG credit assets in 2023, the strongest annual figure since the “flight to safety” pandemic-era flows in 2020.[ii] The surprisingly big flows were driven by flows into fixed-maturity mandates as investors looked to capture the attractive yield on offer.[iii] Traditionally, pension funds and insurers have been the largest buyers in the euro IG credit market, but they retreated after the rates shock of 2022 and have yet to meaningfully return. Historically, pensions and insurers have been slow to return to markets after such a shock. That said, euro IG credit spreads tend to rally about six months after a peak in interest rates; if interest rates have indeed peaked, we believe pensions and insurers may step back in to the euro IG credit market and provide a potential tailwind in the first half of 2024.

[i] World Economic Forum, 15 December 2023.

[ii] JP Morgan Outlook & Strategy, 14 November 2023, and JP Morgan, European Credit Fund Flows, 5 January 2024.

[iii] JP Morgan Outlook & Strategy, 14 November 2023.

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