2023-12-19 05:30:00
For investors who have defied their “bonds are back” call during a turbulent year, eurozone debt has been the big winner and a sour economy and tighter purse strings mean its appeal will continue in 2024.
The euro zone government bond market, worth around $10 trillion, is expected to return 6.5% this year, representing a rebound following two years of negative bond yields at globally due to soaring inflation.
The market has significantly outperformed U.S. Treasuries, up 3.5% this year, and British bonds, up 2.4%, according to ICE BofA indexes.
Italian bonds, at the epicenter of concerns over the impact of interest rate hikes at a record pace, returned almost 9%.
For some, this is just the beginning.
“Most of our bullish positions in bonds are now through Europe, because that’s where the growth is weakest,” said Mike Riddell, senior portfolio manager at Allianz Global Investors, which has shifted away from the States. -United and Canada for the benefit of Europe.
Inflation in the Eurozone is falling rapidly and a recession looms at the end of the year. According to Archyde.com polls, the European Union is expected to grow by only 0.6% next year, half the rate of the United States, strengthening the case for German bonds, which are a safe haven.
A €60 billion hit to Germany’s budget by the Constitutional Court might reduce next year’s growth by 0.5% as Berlin cuts spending to return to a “brake to debt” limiting new borrowing.
A STRICT TAX POLICY
Chris Jeffery, head of rates and inflation strategy at Legal and General Investment Management, said the German court’s ruling supports his decision to favor European bonds over U.S. Treasuries.
“It will be a tighter fiscal policy that is big enough to be macroeconomically relevant,” he said, noting that the German spending cuts come as euro zone finance ministers are trying to reform their budgetary rules for member states seeking to limit deficits.
Another advantage: Unlike the United States, none of the euro zone’s major economies are holding elections next year, eliminating a potential source of additional spending pressure in a year when spending needs financing are high, as central banks continue to reduce their balance sheets.
The euro’s financing needs are also high, but the new debt that investors will have to take on following the European Central Bank’s purchases is closer to that of this year, when investors will have to adapt to an issuance of US debt significantly higher, notes BofA.
The ECB’s decision on Thursday to gradually stop bond reinvestments as part of its pandemic program by the end of 2024, instead of stopping them earlier, reinforced the bullish sentiment.
This plan “is more gradual than expected and should be manageable, not least because the ECB will retain the possibility to use reinvestments flexibly throughout next year,” said Frederik Ducrozet, head of macroeconomic research at Pictet Wealth Management.
These reinvestments support countries such as highly indebted Italy when the ECB chooses which country’s bonds to buy. Italy’s high deficit has raised questions regarding its eligibility for the ECB’s bond-buying program, which will gain importance when the PEPP ends.
HAVE
But there are risks.
First of all, high volatility. The year-end gains follow significant price swings, with bonds taking a hit in February and September. The Financial Markets Association of Europe said Monday that the three biggest quarters in terms of daily bond trading volumes in Europe since 2014 have all occurred this year.
Debt agency officials say hedge funds are helping to fill the void left by the ECB.
Furthermore, a dramatic rally at the end of the year meant that yields on German bonds, which move inversely to prices, fell to levels where some banks predicted they would be at the end of 2024, so that further declines might be limited.
As for Italy, it might lose its luster, especially if the new EU rules renew the examination of its finances. Kal El-Wahab, head of EMEA linear rates trading at BofA, expects eurozone outperformance to be concentrated in Germany, with high funding requirements likely to weigh on Italy.
Any signs of weakening demand from retail investors, who have played a key role in cutting funding to Italy this year, might also weigh on its debt, Barclays warns.
GILT TRIP ?
Across the Channel, Britain is expected to grow just 0.4%, prompting people like Allianz’s Riddell to bet big on British bonds.
However, inflation, anathema to bond investors, remains a bigger challenge. According to a Archyde.com poll, it is expected to reach 3% next year, compared to 2.5% in the euro zone and 2.6% in the United States.
The UK’s financing needs, the second highest on record for the next financial year, are also seen as more challenging.
“We saw a lack of demand from the LDI community throughout the year, which is one of the reasons why (UK) bonds underperformed,” said El-Wahab of BofA, referring to liability-driven investors who invest for the pension funds at the center of last year’s “mini-budget” crisis.
Craig Inches, head of rates and liquidity at Royal London Asset Management, said he was more concerned regarding the size of emissions in the UK, where it holds a “neutral” stance, than in the US, where the reduction in the appetite of pension funds makes him “nervous”.
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