The re-weighting game: European credit losing appeal versus US

July 3, 2024

European spread premia: Compression interrupted

Since mid-2022, there has been significant spread premium in European credit over its US counterpart. This was initially driven by Russia’s invasion of Ukraine in early 2022 and gas supply concerns later that year, followed by elevated recessionary concerns versus the US throughout 2023.

However, during 2024, the premium has shrunk on the back of stronger-than-expected economic data in Europe, particularly in BB-rated credit.

As a result, given spreads no longer look as attractive versus the US, and due to increased political uncertainty in the region, we believe it is time to selectively rotate out of European credit, particularly in high yield.

Europe: Core versus periphery

Given growing political uncertainty in core eurozone countries, we believe the European periphery could offer some shelter from spread volatility as well as opportunities for higher yields.

Current valuations (Figure 2) suggest peripheral European corporate issuers offer better value than the banking sector, with eurozone peripheral banks trading comfortably inside their long-term averages versus their core eurozone counterparts. Until recently, we have preferred the peripheral banking sector, but now see an opportunity to rotate into the broader corporate segment.

Rates: Europe to underperform

As we entered the year, the European Central Bank (ECB) and US Federal Reserve (Fed) were expected to deliver 6 or 7 rate cuts throughout 2024.¹ US and European rates were highly correlated through the first quarter as the market anticipated a synchronised rate-cutting cycle, similar to the co-ordinated rate-hiking path in 2022 and 2023.

However, in April, US rates underperformed as the ECB signalled its willingness to implement a first cut in June, whilst the Fed maintained its higher-for-longer narrative, creating a visible divergence in rate markets (Figure 3).

In May and June, this theme reversed on the back of weaker US data and stronger-than-expected data out of Europe, which resulted in a reconvergence of rate-cut expectations for the rest of 2024.

The rise of non-centrist political parties in Europe is a new source of uncertainty. Combined with our view that the Bund curve remains too inverted for a non-recessionary environment and the resilience of macroeconomic data, this supports our belief European rates may underperform in the coming months.

[1] Bloomberg, WIRP (World Interest Rate Probability monitor), as of January 2024.

This material is not intended to be relied upon as a forecast, research, or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed by Muzinich & Co are as of July 2024 and may change without notice.

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Index Descriptions

HE10 – The ICE BofA ML BB Euro High Yield Index is a subset of the ICE BofA ML Euro High Yield Index (HE00) including all securities rated BB1 through BB3, inclusive.

J0A1 – The ICE BofA ML BB US Cash Pay High Yield Index is a subset of the ICE BofA ML US Cash Pay High Yield Index (J0A0) including all securities rated BB1 through BB3, inclusive.

ICE BofA Euro Periphery Financial Index (EBCA) ICE BofA Euro Periphery Financial Index is a subset of ICE BofA Euro Financial Index including all securities with a country of risk equal to Spain, Italy, Portugal, Ireland and Greece.

ICE BofA Euro Non-Periphery Financial Index (EBCB) ICE BofA Euro Non-Periphery Financial Index is a subset of ICE BofA Euro Financial Index excluding all securities with Greece, Ireland, Italy, Portugal and Spain as the country of risk.

ICE BofA Euro Periphery Non-Financial Index (ENCC) ICE BofA Euro Periphery Non-Financial Index is a subset of ICE BofA Euro Non-Financial Index including all securities with a country of risk equal to Spain, Italy, Portugal, Ireland and Greece.

ICE BofA Euro Non-Periphery Non-Financial Index (ENCD) ICE BofA Euro Non-Periphery Non-Financial Index is a subset of ICE BofA Euro Non-Financial Index excluding all securities with a country of risk equal to Spain, Italy, Portugal, Ireland and Greece.

USGG10YR Index – US Generic Govt 10 Yr. Legacy Government (Sovereign) Generic Index-key ticker.

GDBR10 Index – Germany Govt Bnd 10 Yr DBR. Legacy Government (Sovereign) Generic Index-key ticker.

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