Euro IG & HY Outlook: Icy Roads Ahead

Logan Miller - Head of European Strategy
Winnie Cisar - Global Head of Strategy
Zachary Griffiths, CFA - Head of IG & Macro Strategy
Brian Perez - Credit Strategy Analyst
Kathleen Tang - Strategy Analyst

  • We upgrade Euro IG to an Overweight allocation and maintain a Market Weight allocation for Euro HY, with YE24 spread targets of 130 bp and 425 bp, respectively.
  • In our base case scenario, Euro IG generates excess and total returns of +200 bp and +5.5%, respectively, while Euro HY posts a total return of around +7%. On a probability-weighted basis, our total return forecasts are +4.1% for IG and +5.5% for HY.
  • For IG, we expect robust demand for fundamentally sound credits to continue as yields remain elevated heading into 2024, while the potential for lower policy rates further out should result in a re-deployment from cash into high-quality corporate credit.
  • We are less constructive on HY and expect credit fundamentals and market liquidity to remain challenged next year amid a lag effect of high interest rates and near-term economic weakness, with an expectation that default rates rise toward 4.5% over the next 12 months. Even so, HY should generate above-coupon total return, yet it will likely be a choppy path getting there.
  • We look for the ECB to maintain current levels of policy rates until June 2024 and slowly back off from restrictive territory at alternate meetings thereafter, forecasting 75 bp of cuts in 2024.
  • We expect duration to initially perform well from a total return standpoint on account of weak economic growth in 1H 2024, but acknowledge the potential for bouts of liquidity-driven rate volatility as the ECB’s balance sheet reduction plan persists even after cutting lending rates.
  • We increase our 2024 IG gross issuance forecast to €575 billion as issuers focus in on upcoming maturity walls and modestly lower yields draws in opportunistic borrowing, while we maintain our HY gross issuance forecast of €90 billion.
Macroeconomic Assumptions for 2024:
  • ECB starts cutting policy rates in June 2024. We expect the ECB to maintain current levels of policy rates until June 2024 and slowly back off from restrictive territory at alternate meetings thereafter (75 bp of cuts in 2024). Our view is predicated on the need for the ECB to see continued progress on bringing down core inflation, which may very well come at the expense of economic growth and labor market conditions. Moreover, the ECB’s real benchmark policy rate (nominal deposit rate less core CPI) of 0.4% only recently turned positive and is still well below that of the Fed. In our view, this means the ECB will likely not be the first central bank to starting cutting rates. As such, we expect the ECB to remain in “wait and see” mode for the next six months to avoid the worst case scenario of renewed upward price pressures.
  • Bund 10-year yield to decline modestly to 2.20%. While we could see long-term yields move lower in the near-term on a weakening growth outlook and expectations for ECB rate cuts (which is premature, in our view), a stronger second half outlook and a continued decline sovereign debt holdings by the ECB should result in only moderately lower yields on a year/year basis. Quantitative tightening and the prospect of a further unwind of legacy ECB asset purchase programs remain the key upside risks to long-term yields, as the ECB’s share of central government debt has already declined from the cycle peak of 45% to around 36% at present (versus 29% pre-2020).
  • BoE to move even slower than the ECB. Despite having one of the highest policy rates across developed market central banks, we expect the BoE to remain on hold through the first half of 2024, with additional tightening not entirely out of the question for now. In fact, with core inflation in the UK running at 5.7% in October, the BoE’s real policy rate is still in negative territory at approximately -0.5%. We expect inflation to remain a priority over growth, which is the key driver of our call for restrictive policies to extend through the first half of 2024.

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