Ripple Effects of US Policy On European Credit Markets
Having been in the Euro credit business for more than 25 years, we have never seen such heightened interest for Euro credit from, for example, Asian investors as we are currently seeing. We do not think that this so-called de-dollarization trend is short-term in nature.
How much of an impact have US tariffs had on European credit markets?
While some of the most egregious tariffs that were proposed on liberation day have been rolled back, it's important to remember that the effective tariff rate that the US is now imposing on imports is nearly 10 times higher than it was during the latter stages of the Biden administration and actually comparable to levels last seen in the 1930s. There will clearly be some negative impacts of the tariffs on European corporates, particularly in sectors like automotive and chemicals.
That being said, some of the negative impacts of the tariffs on the health of European corporates are likely to be offset by the significant interest rate cuts the ECB has been implementing during the past two years, as well as expected fiscal stimulus coming out of the recently formed German government.
Whilst we currently see a slightly negative development in the creditworthiness of IG rated European corporates, it is certainly not broad-based, but much more specific to a sector or a company. Please also remember that relatively non-cyclical sectors like telecoms, healthcare, insurance, infrastructure and utilities, and food & beverage collectively make up 35 percent of the index. Furthermore, most companies have been dealing with a multitude of crises during the past two decades, including the great financial crisis of 2008/2009, the Eurozone crisis, COVID-19 supply chain disruptions, and, more recently, the wars in Ukraine and the Middle East.
Management teams have learned, by and large, to navigate such challenging economic conditions by increasing the proportion of their cost basis, it is variable rather than fixed, and by regionalizing or even localizing supply chains. This leaves them better suited to deal with the current uncertainty in economic and trade policy-making.
Which macroeconomic factors are markets underestimating?
We believe the markets may be underestimating the medium to long-term impacts, not only of President Trump's implementation of tariffs on key trading partners, but also of his efforts to gain more direct and indirect influence over the Federal Reserve's monetary policy. Both these issues could have major implications for US economic growth and inflation. At the same time, we've been concerned about the rapid growth in the private credit industry in recent years.
Anytime a huge amount of capital is allocated to a particular debt asset class in a relatively short period of time, the danger of poor underwriting standards and misallocation of capital exists. A potential substantial pickup in defaults and accompanying losses in the private credit space in an adverse economic scenario is a tail risk for the broader market. As such, a scenario would likely result in a lower risk appetite amongst investors.
How important is active management within fixed income today?
In light of where credit spreads are now and the level of spread compression we have seen between, for example, cyclicals and non-cyclical companies, between senior and subordinated bonds, and between bonds with higher and lower ratings, we think active management within fixed income makes a lot of sense.
When spreads eventually do decompress and we get back into a less favorable risk appetite environment than we are currently in, investors will certainly want to avoid holding bonds issued by companies with flawed business models that may fall into financial distress or holding lower-rated and subordinated bonds that are not offering anywhere near sufficient compensation for the underlying risks of the instrument.
In addition, you need to be active to capitalize on the inefficiencies resulting from different objectives and guidelines amongst investors, as well as the opportunities that are available in the primary market.
Can you describe the technicals in the current market environment?
The gross bond supply in investment-grade and high-yield has been approximately 13 percent, which is 8 percent higher than last year as of the end of August. The impact of this additional supply on spreads has been relatively muted so far, as we have seen persistent inflows into the European credit asset class. Part of these flows is likely the result of investors looking to diversify away from dollar-denominated assets, given, for example, the threats to the Federal Reserve's independence and the US's elevated budget deficits.
Anecdotally, having been in the Euro credit business for more than 25 years, we have never seen such heightened interest for Euro credit from, for example, Asian investors as we are currently seeing. We do not think that this so-called de-dollarization trend is short-term in nature.
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