A reconnection between the interest rates of core countries and economic fundamentals will take time: the very clear dichotomy between the growth dynamic and the (currently disappointing) inflation dynamic will have a moderating effect on any upward trend in interest rates.
We must also remember that the combined balance sheets of the central banks will continue to grow in 2018 before reaching a balance by the end of the year, which limits the probability of a hike in interest rates, at least during the first half of the year.
If we continue to witness the normalization of bond yield curves, the accommodative monetary environment should support peripheral debt in the Eurozone and should be a counterforce in the event of a major shift in European interest rates. The increase in government rates that we expect should therefore be moderate which will be key for the other fixed income asset classes.
After a year of very positive performance in terms of European credit, margins have settled at historically low levels. We expect the proportion of Investment Grade credit purchased by the ECB to increase compared with other asset classes eligible for its buyback program, thereby limiting the impact on valuations.
We are positive on financial (bank) subordinated debt given the impact of expected reflation on bank results, the healthier state of balance sheets in the south of Europe, and easing regulatory pressure, following the signature of the Basel IV agreement.
In terms of High Yield credit, the fundamentals are good and default rates will remain very low, well below historical averages. Valuations are high and liquidity is an issue. We will therefore follow closely:
- Investor inflows which have dropped, given performance figures
- The financial leverage of US companies which remains high, making the most indebted companies sensitive to a more aggressive FED.
- The price of oil.
- In terms of emerging markets, Investment flows will continue in 2018, since risk premiums remain very attractive relative to developed markets and to corporate debt.
Many emerging countries will hold elections in 2018, mainly in Latin America. Within this environment, local markets meeting specific domestic requirements should continue to perform well thanks to high real interest rates.
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