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Financial markets have been volatile since the start of 2022. After two years of strong returns and muted volatility, market participants are now trying to navigate an environment where central banks are shifting away from their post-COVID easing policies amid growing stagflationary and geopolitical risk. While news headlines paint a bleak outlook, we have a more sanguine view of where European growth and inflation may be heading over the balance of 2022. Against this more uncertain backdrop, we expect greater volatility, both in spreads and interest rates, but we do not see a default cycle on the horizon. On the upside, European high yield offers substantial income and a relative lack of interest-rate sensitivity. Recent spread widening has created a potentially attractive entry point into the European high-yield market for investors looking to capture income and total return.
Since the global financial crisis, the European Central Bank (ECB) has supported the financial system with quantitative easing, acting as both a liquidity provider and suppressor of volatility. However, more recently, the ECB has had to reassess its accommodative policy stance due to rising inflationary pressures in the wake of the COVID-19 crisis. This trend has been exacerbated by Russia’s invasion of Ukraine, which triggered a sharp spike in European commodity prices as the region tries to reduce its reliance on Russian oil and gas.
While rising inflation is likely to weigh on Europe’s economic outlook, we still anticipate growth to be positive for the region in 2022. Even after adjusting our estimates to account for the dual shock of the Russia/Ukraine war and a slowdown in China, we project growth of 2% – 3% for the eurozone in 2022. Further, while currently at elevated levels, we expect inflation to trend downwards over the remainder of 2022, to around 2.5%.
Significantly, our proprietary country vulnerability framework, which assesses creditworthiness based on six key macroeconomic factors, currently ranks Europe favourably, as highlighted in Figure 1, which shows the strength of Europe’s overall fundamental score relative to its history. Based on this analysis, European corporate fundamentals remain intact and, as such, we view any further credit spread widening as advantageous for European high yield.
In this type of volatile environment, we believe deep fundamental research is critical to identifying companies with sustainable business models that can bring about further credit improvement. While European high-yield issuers have generally been focused on balance-sheet improvement since the start of the COVID-19 crisis, we are beginning to observe more aggressive financial policy behaviour from some issuers, as evidenced by a modest increase in the use of issuance proceeds for dividends and acquisition financing.
The rapid increase in European regulation related to sustainability is likely to expand the gap between the best- and worst-performing companies in this opportunity set. Equally, as investor trends react to these regulations, we expect companies with stronger ESG credentials to experience higher capital flows. Having the ability to identify the more promising ESG performers through fundamental research can, in our view, be an alpha driver in managing European high-yield portfolios. We therefore incorporate ESG themes into our security-selection process to help identify companies with the potential for attractive long-term performance. Through our research, we have found that social factors such as corporate culture and employee satisfaction rates tend to most directly impact a company’s ability to produce sustainable cash flows. This is, in part, because companies with higher employee satisfaction rates tend to have lower personnel turnover and stronger cultural values, resulting in a more productive and experienced workforce.
The recent increase in volatility has put upward pressure on both interest-rate and credit markets, causing option-adjusted spreads for euro high yield to widen to 474 basis points as of May 31. Euro high-yield spreads, as measured by the ICE BofA Euro High Yield Constrained Index, now rank in the 71st percentile relative to history, creating attractive buying opportunities in the asset class. This is particularly true for investors looking for income and total return because high-yield issuers offer significantly greater yields relative to government and investment-grade bonds, as depicted in Figure 2 below, with the added benefit of being less volatile than equities.
As the ECB continues its path towards less accommodative policies, we expect yields to continue moving higher, which, compared to the broader fixed income markets, may favour European high yield as the asset class tends to be more insulated from rising interest rates given its generally lower maturities than traditional fixed income assets. This environment could provide a compelling backdrop for European high-yield investors with access to the deep fundamental research expertise to help reposition their portfolios for this fast-changing world.
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