In this analysis, Benoit Anne, Managing Director – Investment Solutions Group, MFS Investment Management, shares his reasons for thinking the case for duration is stronger in Europe, why the ECB may be better positioned to cut rates next week, why Europe prevails in the credit fundamentals category and why broader financial conditions are more supportive on the continent too.
Europe vs. USA. “There are a number of interesting drivers of differentiation between Europe and the US these days, which may help generate attractive relative value opportunities for fixed income investors with a global remit. Overall, we believe that European fixed income is better positioned“, says MFSIM’s Benoit Anne.
ECB to ease more than the Fed.
“The first point for Europe is scored in the monetary policy game. A rate cut delivered by the ECB next week is very much a possibility whereas on the Fed side, the likelihood of a June cut is now extremely low, if not nil. Over the next six months, the rates market currently prices in 52bp of ECB cuts against only 21bp of cuts for the Fed[i]. This means that from a monetary policy standpoint, the macro environment is more supportive for European fixed income.
The case for long duration is stronger in Europe.
“Reflecting partly the view on monetary policy but also the more supportive macro backdrop, the case for being long duration is arguably stronger for the Eurozone. In the case of the US, there is some uncertainty in the near term surrounding the Fed policy outlook and the speed of the disinflation process. This in turn has caused an elevated level of rate volatility, a near-term roadblock for investor appetite to fixed income. At a strategic level, we nonetheless remain of the view that the case for long duration is well established both in the US and in Europe, given where we are in the rate cycle and the attractiveness of total yields.
Europe also prevails in the credit fundamentals category.
“A look at asset class fundamentals suggests that the fundamental backdrop is stronger in Europe. To be clear, based on our fundamental credit score—which includes three key indicators, namely net leverage, EBITDA margins, and free cash flow to debt—US IG fundamentals remain broadly adequate, as they seem to be in line with their long-term average. But EUR IG fundamentals appear to be considerably more solid, mainly reflecting the strength of free cash flow generation and historically low levels of leverage. Likewise in High Yield, our fundamental score for EUR HY is markedly stronger than for US HY. This may explain why Moody’s forecasts for HY defaults are noticeably lower for Europe than for the US.
The valuation backdrop is also skewed in Europe’s favor.
“Moving on to fixed income valuation, again advantage Europe. Overall, there is no denying that outright fixed income spreads look stretched in many segments of global fixed income. Call that fixed income being victim of its own success perhaps. But while both US IG and US HY spreads screen as overstretched, EUR IG and EUR HY spreads are only in moderately rich territory. In addition, when looking at break-even spreads, our preferred spread valuation indicator, the picture looks even more favorable for Europe. In break-even spread terms, EUR IG valuation looks fairly close to its long-term fair value while EUR HY valuation is still in moderately attractive territory. This contrasts sharply with the valuation assessment for US credit, with US IG break-even spreads looking quite unattractive at this juncture. The good news from a valuation standpoint is that total yields still look elevated by historical standards, both in the US and Europe, which is what ultimately matters for the long-term investor.
Broad financial conditions are more supportive in Europe.
“When looking at the recent history of financial conditions on both sides of the Atlantic, the tightening of financial conditions has been more severe since end-2021 on the US side, mainly owing to the more aggressive policy adjustment. With looser financial conditions being viewed as supportive of risk sentiment, this tends to benefit Europe on a relative value basis.“
[i] Source: Bloomberg. Based on forward cash curves. Data as of 24 May, 2024.
