What Is Happening in Europe?

It is summer, so I’ll make this short.

The ECB is still trying to define what is the “anti-fragmentation tool” and its rules and details. Its name, in a tentative move to make it more attractive, has already been changed to “transmission protection mechanism” (TPM), but the instrument has started to attract the negative attention of the usual countries: Germany and the Netherlands. The same happened 12 years ago, so this is not a surprise. Maybe the statements coming from those countries (Bundesbank and Dutch PM) are simply the obligatory remarks that need to be made for public opinion or the Parliamentary bodies, but I was expecting this continued reluctance to extend support for the most indebted countries of Europe. The Bank of France hopes the instrument, whatever its name, will never be used and it could work as a deterrent tool (remembering the famous bazooka in the pocket of the US Treasury Secretary Henry Paulson). My view is what I expressed in the last post: having the possibility and the willingness to smooth the volatility in government bond yields is not in contrast with a more restrictive monetary policy. Rates will need to adjust to a different interest rate environment and their rise is logical, but they need to do this move in an orderly manner and this is exactly the opposite of what happened in the first six months of 2022. The urgent ECB meeting of June proves that something went wrong, and the malaise is not only linked to some unfortunate press conferences. The credit market stopped working due to the excessive volatility. Borrowers have understood the new financing rates, but the investors still do not want to put money on the table in an unstable environment where the mid-swap curve can perform daily swings of 15 bps. Any nation’s debt sustainability issue and not a simple spread differential (which is fundamentally correct) is an enormous obstacle for investing with conviction in a government and credit portfolio. The European curve was helped in the month of June by the ECB’s promises and a soft repricing of the US yield curve due to the economic uncertainties. But peace might not last forever. The “optionality and flexibility” of the ECB could be tested soon. If the new tool, as I wrote last time, had been prepared and announced differently, the markets would have been left guessing the Central Bank’s strategy but knowing it was there. The bazooka effect could have worked even this time.

I don’t see any possibility at this moment for a spread differential tightening trend for the peripheral countries against core. I don’t see the fundamental drivers for this prediction. If we take the Italy-Germany 10Y spread difference for example (I forecasted its widening when it was at 100 bps at the beginning of Q4 2021), we can notice how we are back in the channel 170-200 bps in place since mid-April (the peak was at 237 in the second week of June). It is unlikely we will trade outside this range in the short term.?The surprises remain more on the upside (200-230 bps), simply because the risk in the Euro area is tilted to a spread widening. But there are more elements at play to support my view. There is only one possibility why this trade could not work: a very big macro recession in the Euro area caused by an energy crisis. If this proves to be correct, there will be more serious problems to deal with.

Credit markets remain closed for non-investment grade credits. The IG space remains active mainly on financials, insurers and strong industrials. The HY still struggles in a risk-off dynamic where single B names suffers the big dispersion of rates since the great financial crisis. The William Hill ( 888 Acquisitions Limited) pricing is not a benchmark for the B cohort due to its ESG considerations, but any other sector suffers uncertainty in assigning the correct spread level for the amount of risk taken.?For strategic allocation, I deem the BB rated space (hybrids and sub financial included) offers interesting returns and it is worth taking more duration in the curve after the 6-7 year tenor. The European credit curves will flatten toward the end of the year and coming into 2023 when the acknowledgement of a weaker growth will be clearer.?Solid B names remain a strong buy in the 2-3 year duration.

For the last point I would like to discuss the illiquidity of the European credit market. Something I mentioned at the end of the last post. The illiquidity phenomenon explains why some opportunities remain overlooked or some more troublesome credits still quote too high in price. The US market suffers from the same malaise, the interest rate repricing and credit concerns, but not in the same proportion as Europe. The credit illiquidity is visible to everyone, and it can clearly be appreciated in the disconnection between HY cash prices and XOVER. This disconnection is evident, and it has been the major trend in Q2 2022: the distress part of the HY market with prices below 80 pct (more than 25% of the market nowadays), does not move when the XOVER rallies in the good days. Similarly, bad or weak days are characterized by significant drops in prices while the derivative market reaction remains more muted. The inflows and outflows from the bond market, when taken alone, are not able to provide a satisfactory explanation. Other factors are possible:

a) investors’ attitude toward the biggest market movement since the GFC and their inability to forecast inflows and outflows in the funds under management,

b) the investment judgement or strategy from some investors which doesn’t fit with a different credit market never seen before,

c) some IG investors, before active in BBs, are completely out of the market,

d) trading desks unwilling to provide prices and liquidity to participants (banks are full of debt from underwritten deals),

e) distress buyers on hold because some valuations are still excessively high for their investment return expectations,

f) the diminished role of the Central Banks in providing a support and back stop (and a distortion in risk premia) in some parts of the credit markets and inevitably in the HY space.

g) maybe, we still don’t find the investors who can substitute the Central Bank as the main buyer of the market in the switch “public to private” that I have mentioned some posts ago

h) the technical consideration of dearth of supply from the primary market which kept some secondary prices artificially high against market conditions and cancelled any idea of price discovery for investors.

The picture is not good, and I don’t remember to trade in similar conditions except in some months of 2008.

Companies’ earnings or corporate actions are not shaking this lethargy. Balance sheet exercises done in these days where companies are launching bond tenders for their own liabilities do not have any value or indication about the health of the credits involved (some banks were doing this activity back in 2008-2010 and they have defaulted anyway sometime later), neither they provide a directional signal.

How to profit, if possible, from this situation?

My strong feeling is that in some parts of the credit market there are interesting yield levels that should clearly compensate investors going through a moderate/high default cycle. I don’t predict default rates in Europe to spike above the long historical average even in a flattish growth economy and such a scenario is perfectly manageable for good credit managers who should be able to avoid or limit the idiosyncratic risk that I see emerging in some fragile credit names. Buying and selling in this market requires a lot of time and patience.

Author: Sergio Grasso , director at iason

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