Volatility in government bond markets, but calmness in credit markets
So far, 2024 has kept fixed income investors busy, with a blockbuster new issuance calendar, a pivot from the Bank of Japan and heightened geopolitical tensions in the Middle East all competing for the market’s attention. Yet inflation — stubbornly lingering above target — has remained the dominant theme, resulting in increased government bond yield volatility as the market has walked back expectations for central bank rate cuts throughout the remainder of the year.
Credit markets, however, paint a different picture. European credit markets have remained notably strong. Spreads have tightened, supported by robust corporate balance sheets, a resilient consumer and favourable market technicals. Yet despite tightening, European investment-grade credit continues to look appealing, providing historically high all-in yields of 3.9%, allowing investors to benefit from attractive income without the need to take excessive risks. What do investors need to know about opportunities in European credit and what could the rest of the year hold?
Understanding the cycle
Understanding the credit cycle — the recurring phases of expansion and contraction in the availability of credit — is a crucial ingredient for successfully managing European investment-grade credit portfolios. Specifically, by anticipating changes in the cycle and dynamically managing overall credit exposure, we aim to participate in the upside while preserving capital on the downside. Put simply, there are times we want to have more exposure to credit, and times we want to have less. Through our active approach to managing credit risk, we seek to insulate clients from the volatility of the credit cycle and aim to provide them with a smooth, consistent return stream of outperformance.
We seek to understand the cycle by paying close attention to the strength of corporate balance sheets, the resilience of the consumer and the speed at which changes in interest rates are transmitting through to the economy. Despite one of the most aggressive rate-hiking cycles in history, European Central Bank (ECB) policy appears to be working, albeit with a longer lag than in previous cycles. Combined with rebounding growth, we believe that credit should remain supported in the near term. We have identified three potential drivers of an extension to the credit cycle:
1. Healthy household balance sheets support consumer spending
Within Europe, household balance sheets remain healthy, with disposable income near 25-year highs (Figure 1). In part, this is because since the global financial crisis (GFC), European consumers have significantly changed their behaviour through saving more and shifting away from riskier forms of borrowing. There have been two further changes: the pandemic saw many consumers build up savings and European homeowners increasingly choose fixed rate over floating mortgages, meaning that today, the average European household is in a much stronger position relative to history, as well as being less sensitive to changes in interest rates.
As inflation comes down from its peak, wage growth and proactive fiscal policy has led to higher real incomes. Consumer balance sheets remain much stronger than historical averages, which should support continued spending — and corporate earnings — in the near term.