Institutional Money (04.06.2021) - Having trailed other regions in the recovery post-Covid, we now expect Europe to outperform as a number of key factors pivot in the continent’s favour. This bodes well for European credit and in particular higher-income segments, such as high yield and AT1s.
The global vaccine roll-out has had a positive impact on economies. To date, Europe has lagged behind, but with increased production and distribution set to accelerate, the likelihood is that coverage rates will exceed the European Commission’s target of having 70% of EU citizens inoculated by the end of September 2021. This in turn will allow for the continued reopening of economies, which will be of particular benefit to the services sector. In addition, as a consequence of lockdowns and the inability to visit shops or travel, savings rates in Europe have increased dramatically, almost doubling from more typical levels. We expect these excess savings to be spent, with potential for larger marginal gains in peripheral Europe given their higher reliance on tourism. At a more macro level, Europe too should benefit given its large open economy and the fact that its two largest trading partners, the US and China, are further along the growth path.
Despite the positive consumption backdrop, we expect monetary and fiscal stimulus measures to be maintained.
The ECB will keep financial conditions loose by maintaining its quantitative easing programme, and the bank is not expected to increase the deposit rate for a number of years, i.e. much more slowly than the Federal Reserve. On the fiscal front, by the end of this year, we should see the first disbursements of the EU Recovery Fund; this is a pan-European solution that offers sizeable grants and loans to countries most badly affected by COVID-19. This should help boost investment and thus further strengthen GDP. Although these measures and others, such as supply chain disruptions and base effects, may lead to an uptick in core inflation, we expect this to be temporary given the structural headwinds within Europe, which include the persistently high level of labour market slack. As such, policymakers can bide their time and not rush into tightening financial conditions early, a mistake the ECB has made in the past and not one that it is looking to repeat.
This is a positive environment for credit. With growth expected to accelerate, revenues and earnings of European companies should increase. At the same time, the cost of debt will remain at historically low levels. The European high-yield segment did remarkably well in the crisis, despite its severity, and managed to avoid excessive defaults due to the various effective government furlough schemes. We expect this risk transfer from the public sector balance sheet back to the private sector balance sheet to be smooth given the favourable economic environment, allowing European high yield to continue to produce income for investors while avoiding a secondary wave of defaults.
AT1s, subordinated banking debt, should also perform well over the medium term.
In addition to the positive macro environment, at company level, banks have recently reported very strong earnings, with most beating expectations and continuing the trend of maintaining strong capital ratios. AT1s represent a fixed-income segment that stands out, given that the spreads offered today have not recovered to their pre-Covid lows, making the asset class particularly appealing.
In conclusion, Europe did lag behind the post-Covid recovery although there are encouraging signs that this is changing. Given the numerous tailwinds now in Europe’s favour, we would encourage investors to look at the European fixed-income market, and in particular the higher-income segments, as an opportunity in the medium term.
Philippe Graüb
Head of Fixed Income
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Bernard McGrath
Senior Investment Specialist
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