inakiantonana
By Simon Matthews
We think the rally in European credit that started the year has legs and expect spreads in the region to outperform after the hailstorm of 2022.
What a difference a few encouraging data points and a bit of mild weather can make! There’s still a long way to go this year, but European credit has started 2023 with a bang, continuing the performance from the fourth quarter with European investment grade and high yield credit both up between 2.5% – 3% year-to-date through mid-January.
In the aftermath of the invasion of Ukraine, the vulnerability of Europe’s energy ecosystem has been one of the principal concerns for European corporate issuers. The prospect of gas rationing, particularly for energy-intensive firms was a key driver of underperformance in Europe last year. The rapid repricing of natural gas futures and electricity in recent weeks has gone some way to alleviate those concerns. Mild weather, yes, but also the restart of several nuclear power stations in France has swung the balance meaningfully. Headline inflation, the scourge of households and businesses alike, particularly in Eastern Europe, may even move into negative territory in the coming months given the sharp decline in energy pricing and with food and other inflation components rolling over.
Additionally, Europe’s more open economy arguably benefits more from China’s nascent but rapid reopening than the more domestically focused U.S. economy; and, in times to come, European countries’ infrastructure investments should help bolster energy independence. Certainly, the fiscal support provided in Germany and elsewhere looks to have cushioned the impact on consumers of the energy situation last year. We would also note the recent uptrend in Eurozone PMI, which is currently near a record high relative to U.S. PMI.
Since last October, when the option-adjusted spread (OAS) for the European high yield hit a high of 160 basis points above that of the U.S. high yield, we have seen around half of that “Europe premium” unwind. (The OAS differential as of January 13 was 65bps.) Similar outperformance has occurred in European investment grade credit, which since the recent spread wides in October has seen almost twice the level of spread tightening as U.S. investment grade.
In the near term, with support from improving European data and, in some markets, a firm technical backdrop, we expect credit spreads in Europe to continue to outperform. Many variables exist, but we see a few fundamental reasons why European spreads should not unwind the remainder of their premium to other global credit markets by the latter part of 2023.
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