The rise of European fixed income

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Expectations of a recession in the Eurozone have flattened core sovereign curves, likely too much in the short-term. As these curves eventually back-up, we see strategic opportunities to eventually go long core and peripheral yields and, over time, the lowest tranches of credit in a rising spiral of risk taking.

A mostly normal recession, if it comes

Economies oscillate around a very predictable long-term trend that is largely a function of rising productivity, a growing population and long-term ecological trends. Such trends, if strong enough, encourage a rapid build-up of leverage to invest and benefit now from future growth. We expect this long-term trend to hold and the risks to be mostly normal cyclical ones, though some are clearly not. These trends can become unsustainable when internal and external imbalances build up (e.g. an expensive real estate market or a weak currency such as in Turkey).

We are faced with five shocks: 1. Inflation 2. Excessive debt especially in the European periphery (easily dealt with by the ECB’s Transmission Protection Instrument (TPI), provided the political will for reform is there) 3. Excessive borrowing by households for real estate investments, which should eventual dampen consumption as finances get stretched. 4. Strong odds of natural gas shortages over the winter that could plunge Germany into a recession. 5. A significant slowdown in the Chinese economy.

As can be seen in the graphs below, the odds of a recession are rising and elevated at 45% (Chart 1), but are not yet the consensus of economists (Chart 2). To have a deep recession, one would need something to break from severe shocks to the European economy and we are very far from this. That surely leaves us with a classical recession. Over time, inflationary pressures should ease and expected growth recover encouraging both corporates and households.

Probably wait tactically to extend duration in core curves

Rising fears of a recession in Europe and China have pushed back-end European sovereign curves significantly lower. Much of the market seems to believe that the labor market will naturally cool itself before an inflation wage spiral forms. As a consequence, the ECB is expected to stop hiking around 1%, 40 basis points lower than a month ago (see Graph next page). This is unlikely as it implies a rapid economic slowdown.

What does it mean?

Tactically, we would wait for higher core yields as the risk of a wage inflation spiral is under-estimated and inflation is not yet under control. But structurally, we continue to like risk in peripheral yields where reform is still expected and where the political situation is encouraging such as in Italy. Longer-dated Covered bonds are increasingly of interest. In addition, flexible fixed income solutions are dynamic in duration but also have a broad investment universe. After a while, the spiral of risk taking in fixed income should slowly – and eventually rapidly – amplify. When the market finally figures out that we are facing a mostly classical recession, the attention should focus on High Yield.

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