In developing our investment strategy, we consider both the baseline case of the European Central Bank (ECB) on hold, but also the possibility that the ECB will be forced to purchase assets, in the form of credit easing or QE, to head off deflation risk.
For core eurozone duration, we favour an overweight in the 5-10yr part of the curve. The carry is attractive and, in the event that the ECB moves toward asset purchases – or if the market merely starts to anticipate that ECB asset purchases are more likely – we would expect the belly of the curve to outperform the long end of the curve.
We regard long-dated forward rates in the eurozone core curves as structurally rich, reflecting demand for long-dated bonds from liability-driven investors. Rather than running an overweight duration position overall, we will run curve steepener positions by underweighting the long end of the curve.
This reflects two considerations. First, our view on the eurozone and the positive carry of curve steepener positions; and second, the possibility that US interest rates will rise, dragging eurozone rates higher with them – as in 2013.
Looking at the UK, we are underweight UK duration given the relatively low level of yields and the prospect of the Bank of England’s tightening cycle.
We remain overweight eurozone peripheral risk, favouring Italy, Spain and Slovenia and positioning at the front end out to the five-year part of the curve, where the curve is steepest and where we can generate the most attractive income. Our baseline case is that spreads should be range bound. We continue to have concerns over the medium-term growth outlook in the eurozone, and we continue to see these positions as a source of credit risk and scale them appropriately.
In the event of ECB asset purchases, we would expect peripheral government debt to be a primary beneficiary – even in the event that the ECB focuses its purchases on credit and loan markets – and we would look to increase our holdings if the probability of QE by the ECB were to rise.
We are broadly neutral on corporate credit and will continue to look to generate alpha across European credit and asset-backed markets. European credit default swap (CDS) indexes look reasonable value compared to US CDS indexes. But strong demand from European insurers means that euro-denominated cash bonds remain expensive compared to dollar and pound sterling bonds, after hedging the exchange rate and duration risk. Within Europe, we continue to find good bottom-up opportunities in companies that are still implementing restructuring plans.
We do not expect the ECB’s ‘Asset Quality Review’ to result in a significant capital hole for the eurozone banking system. However, there is already evidence that banks are responding with more conservative non-performing loan provisioning and capital raising. Subordinated and hybrid bank capital should benefit most from this, particularly against the senior part of the European bank capital structure which continues to trade rich compared to US and UK peers.
