As for most global risk assets, 2022 was a terrible year for euro Investment Grade (IG) bonds. This was owing to a near-perfect storm of negative conditions. In particular, inflation came back with a huge bang, causing central banks to raise interest rates aggressively from historically low levels. Even more unexpected, 2022 was also the year that war returned to Europe. In turn, this compounded inflationary problems and raised major concerns about regional energy security and recession risks.

However, the good news in early 2023 is that all the key negatives of the previous year are now on a reversing trend. At the same time, much-improved valuations are reflected in attractive ‘all-in’ yields. This augers well for the persistence of the recent recovery in euro IG credit and the continuation of the long-term trend of negative total-return years being followed by positive ones.

Bloomberg Barclays European Aggregate Corporates Index 12-month Total Returns

Source: abrdn, Barclays Live, 31 December 2022

Inflation moving in right direction

First and foremost, declining inflationary pressures support the outlook for euro IG credit. As shown below, the October inflation high point of 10.6% year-on-year in the euro area looks like a peak, given subsequent monthly readings of 10.1%, 9.2% and 8.6%. Further, this trend should continue over the coming months, thanks to markedly lower energy prices, reduced supply chain issues and increasingly favourable base effects. For its part, the European Central Bank (ECB) is forecasting euro area inflation of 3.6% by December 2023.

Eurozone Consumer Price Inflation

Source: Bloomberg, February 2023.

The key significance of the more benign inflation outlook is that it eases pressure on the ECB to continue aggressively hiking interest rates. In this regard, it’s worth remembering that 2022 saw a stunning jump in 10-year bund yields, from -0.18% at the start of the year to +2.57% by the end, to the detriment of all euro bonds. In terms of the outlook, however, while some further ECB hiking is anticipated in 2023, this looks largely baked into current market expectations, with low overshoot risk. As such, the downside scope from further significant bund yield rises seems limited.

Collapsed gas prices and eased recession fears

In 2022, the other dominant concern for euro bond markets was the unprecedented run-up in gas prices, the hugely damaging consumer and business impact of which stoked real fears of recession. Indeed, an almost four-fold increase in natural gas prices by late August was linked in large part to fears of potential supply disruptions due to the Ukraine war. However, such fears have been mitigated, with gas prices down by 85% from last year’s peak and back to pre-war levels.

Going forward, we think the likelihood of another big run-up in gas prices in both the current and next winter should be reduced by improved gas supply diversification in Europe, as well as increased gas in storage. Accordingly, recession risk for Europe has lessened greatly, which is a major positive for euro corporate bonds.

China reopening a positive for Europe

Although not quite as preeminent as the previous factors, another positive reversal point is China’s significantly improved growth outlook following its recent ‘reopening’. The European corporate sector is relatively highly exposed to China through the trade and tourism channels. In terms of total trade (exports and imports), China is the EU’s biggest trading partner (16% of total in 2021). China’s post-zero-Covid growth is likely to be consumption-led, which should help European goods exports.

On the travel side, China’s increasingly important role as a travel services ‘importer’ is often underappreciated. Following recently eased Chinese outbound travel rules, Europe should be among the biggest beneficiaries of increased Chinese tourist inflows. Combining all channels, we think a +1% increase in China’s real GDP growth should translate into an uplift of 0.1%-0.2% in European growth.

“…it’s worth remembering that as recently as August 2021, the all-in yield for euro IG corporates was below 0.2%.”

Valuations and yields

The other critical factor for euro IG credit is attractive valuations, which is reflected in index level ‘all-in’ yields above 4%. This is the result of significantly higher bund yields and credit spreads above long-term averages, despite the significant compression of recent months as recession fears eased. To put the valuation point into perspective, as recently as August 2021 the ‘all-in’ yield for euro IG corporates was below 0.2%.

Highest Europe IG bond yields in over 10 years

Source: Bloomberg, February 2023.

Supportive euro hedging costs

One additional point to note, in particular for US and US-based currency investors, is significantly reduced euro hedging costs of late. Taking these changes into account, the euro IG credit market, in a pronounced reversal of the norm of recent years, is now offering a significantly higher currency-hedged yield (about +120 bps) than the yield for US dollar IG corporate bonds.

Putting everything together

Despite the robust rally of recent months, we are positive on the 2023 outlook for euro IG credit. This reflects a favourable reversal of the negatives of last year, including declining inflation, reduced recession risk and a much stronger growth outlook for China. At the same time, the valuation picture is also significantly improved, thanks to ‘all-in’ yields now above 4%.