French President Emmanuel Macron’s decision to call a snap parliamentary election drove European sovereign and corporate spreads wider in June. French government and corporate bonds bore the brunt of the sell-off seen in credit markets, with losses pared following the results of the French parliamentary elections in which the left coalition spearheaded by Jean-Luc Melenchon obtained the largest share of parliamentary seats.
Despite the turmoil caused by French politics, European primary markets and fund flows during June continued to support European credit markets, particularly High Yield (HY), which reported cumulative fund flows of circa €3 billion on a year-to-date basis compared to €1 billion during the same period last year.
Furthermore, within the Investment Grade (IG) space, investors preferred to increase their exposure to longer-dated paper versus shorter-dated paper as investors’ rationale in locking in a high level of yield persisted given expectations of lower rates over the coming quarters. Further supporting European credit, investment houses have revised upwards their supply forecasts for both European IG and HY paper for the remainder of the year compared to forecasts published earlier this year.
With the political uncertainty in Europe seeming to have subsided, the market quickly shifted its focus to the European Central Bank’s (ECB) Governing Council meeting and economic data.
While the ECB kept rates unchanged as was widely expected, President Christine Lagarde refrained from giving any guidance on the central bank’s next decision several times during the press conference held but instead noted that several economic data points are set to be released over the coming weeks and months as she emphasised that wage data, particularly wage growth, which has been sticky of late, will be of particular importance as expectations are for wage growth to decline over the coming two years.
Despite Lagarde not committing to the ECB’s rate path, market expectations are that the ECB will lower rates at its September meeting.
On the other side of the Atlantic, while the upcoming US election set to be held in November is starting to take centre stage, with former President Donald Trump currently leading in the polls, the Federal Reserve’s rate path and economic data remain front and centre, with many FOMC members signalling that the Federal Reserve is inching closer to a rate cut.
US labour market data remains robust, despite showing some signs of weakness lately, with the consumer also displaying signs of strength given recent retail sales data as the tight financial conditions have done little to dampen consumer expenditure.
The recent publication of housing and industrial production also came in above consensus forecasts while ISM surveys have shown that manufacturing is contracting as per the last reading. Given this scenario, second-quarter GDP estimates have been marked higher as the Atlanta Fed is tracking 2.70% real GDP growth.
Looking ahead, expectations are that corporate credit spreads will tighten further from their current levels both in Europe and the US while sovereign yields are expected to inch lower till year-end from current levels. The rationale behind such forecasts are expectations of a looser monetary policy regime both in Europe and the US, together with an improving European economy and a still robust American economy despite some weakness as of late.
However, despite the positive forecasts for fixed income markets, there are risks that investors need to be wary of. Firstly, as the US presidential election approaches, volatility within fixed income markets may increase. Secondly, the Chinese economy may be a driver of European risk in terms of possible economic downside given that the European economy is a net exporter to the Asian country, while electric vehicle competition intensifies between the two economies, with the possibility of an escalation of tariffs also within the realm of possibility.
Thirdly, the political situation in France could increase the level of friction with the European Commission due to the French economy’s fiscal sustainability, which may lead to a downgrade of France’s sovereign rating.
Simon Gauci Borda is a fixed income analyst at Curmi and Partners Ltd.
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd is a member of the Malta Stock Exchange and is licensed by the MFSA to conduct investment services business.