Treasuries Will Leave Europe’s Bonds within the Dust, Investors Say

(Bloomberg) — The inflation fight in Europe will drag for thus long that it’s going to tarnish the appeal of the region’s debt this 12 months, a survey of investors shows.

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The European Central Bank’s deposit rate will top 3.5% after one other 1.5 percentage points of hikes, in response to greater than a 3rd of 201 investors in the most recent MLIV Pulse survey. A further 15% see it heading to 4% or above, which could be a record level. That helps explain respondents’ strong conviction that euro area bonds will underperform US Treasuries this 12 months.

The Federal Reserve “seems closer to ending the cycle than the ECB” and there’s also “greater uncertainty” over where euro-area rates peak, said Rohan Khanna, rates strategist at UBS Group AG. With possible Fed cuts later this 12 months and a wave of supply from European governments, the outperformance of Treasuries versus bunds is certainly one of his top trades.

Market bets on the ECB’s peak rate have slipped in recent days, falling back below 3.5% for July, in response to swaps tied to central bank meetings. Greater than half of survey respondents see the speed not peaking until the third quarter or later.

There’s been no lack of warnings for investors from policy makers: ECB Governing Council Members Olli Rehn and Pablo Hernandez de Cos are the most recent to say there are still “significant” rate rises ahead.

At the guts of their concerns is the euro area’s core measure of inflation, which strips out food and energy. It rose to a record high of 5.2% in December at the same time as the headline figure declined to 9.2%.

Meanwhile, within the US, slowing inflation is fueling expectations that the Fed is about to rein in its aggressive cycle of hikes. Markets at the moment are leaning toward a 25 basis points increase come February, which could be the smallest in nearly a 12 months. Jupiter Asset Management sees 10-year Treasury yields slumping as little as 2%, in comparison with around 3.40% now, as a world downturn pushes investors toward haven assets.

Blowout Risk

The expectation of further significant ECB tightening helps explain one other response to the MLIV survey: about 72% of investors think it’s very likely or somewhat likely that the central bank may have to make use of its Transmission Protection Instrument, a bond-buying tool to mitigate financial stress.

Contrast that to comments by ECB officials, who’ve said they hope the TPI won’t be used and that its existence alone will likely be enough to avert unwarranted selloffs within the region’s riskier sovereign bonds.

“I feel there’s a non-trivial probability TPI will likely be used, should you take into consideration raising rates and the large supply coming,” said Greg Peters, co-chief investment officer at PGIM Fixed Income. “They will’t afford to have Italian spreads blow out.”

A continued hawkish stance from the ECB could derail gains in German debt up to now this 12 months and lift 10-year yields close to three% this quarter, from around 2.2% currently, in response to Societe Generale SA strategists. Consequently, greater than three quarters of those surveyed favored Treasuries over euro-area bonds this 12 months.

While Europe’s headline inflation could also be sticky, not less than it’s on the way in which down. Mild weather has seen the value of natural gas plummet as fuel consumption drops, and stockpiles are fuller than usual for this time of the 12 months. That’s leading greater than 60% of MLIV survey participants to think an energy crisis can now be avoided in Europe in 2023.

The economic outlook has recovered a lot that Goldman Sachs Group Inc. economists now not predict a euro-zone recession for 2023. They now expect gross domestic product to grow 0.6% this 12 months, compared with an earlier forecast for a contraction of 0.1%.

Moreover, China’s seminal u-turn away from its Covid Zero policy is predicted to spice up the world second-largest economy’s demand for European goods. It comes as little surprise that survey respondents see Europe’s luxury and other discretionary consumer stocks as the most important beneficiaries, followed by travel and tourism.

European stocks within the fourth quarter had their best-ever run relative to US peers in dollar terms; that notable outperformance has continued into 2023. Relatively low-cost valuations helped. The Stoxx Europe 600 Index trades at a 12-month forward price-to-earnings ratio of over 12 times, compared with the S&P 500 at about 17. US stocks’ premium is historically pricey.

China’s reopening can be a positive factor. About one-third of survey respondents said luxury and other discretionary sectors would profit most from China’s re-opening, while one other 23% said tourism and travel. Europe is home to some luxury behemoths including LVMH and Gucci owner Kering SA. The MSCI Europe Textiles Apparel & Luxury Goods Index has gained twice as much as Stoxx 600 up to now this 12 months. Luxury stock price levels are trading above analysts’ targets.

While each US stocks and Treasuries are on a roll up to now in January, a majority of skilled and retail investors think those holding bonds will find yourself with higher returns in the following month. The longer-term outlook for equities also looks tough, in response to Marija Veitmane, senior multi-asset strategist at State Street.

“The present state of the US economy in all fairness strong and that’s creating inflationary pressure,” she said in an interview with Bloomberg TV on Friday. “The Fed may have to remain fairly aggressive for longer, with no cuts, and which means deeper recession afterward. In that world, you favor bonds over stocks.”

To subscribe to MLIV Pulse stories, click here. For more markets evaluation, see the MLIV Blog.

–With assistance from Simon White, Heather Burke and Alicia Diaz.

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