multi-asset
US vs European credit: which is more attractive?
Value had a decent 2022 while growth lagged across equity markets. This continued until March 2023, but that trend has recently been reversing. This trade-off is often associated with the relative performance of US and European stocks: US is quality growth and Europe is value, so to speak. In this weekly edition of Simply put, we ask: does the same dynamic apply in credit markets?
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Value versus growth
If equity markets have recently shifted to prioritise growth over value, does the same apply to credit markets? The transatlantic spread – that is, the difference between the credit spreads for bonds denominated in dollars and in euros – could undergo the same shift, with investors demonstrating a preference for quality over value.
Quality in credit markets will likely look different to quality in equity markets. Contrary to expectations, European credit markets are a lot more resilient than they used to be. The European macro situation is also demonstrating a greater resistance to the tightening cycle than in the US, and default projections for both zones now clearly highlight that difference. Finally, in terms of pricing, European and US credit are trading at similar levels – all the more a reason to a have a preference for a reasonably priced quality.
European credit: higher quality
To really understand the current consensus around equities, one needs to measure the quality of the names that comprise the markets on either side of the Atlantic. In the case of European and US credit, investors could still be under the impression that European credit is in a similar position to 2011, at the height of the region's sovereign-debt crisis. The opposite is true, and markets have been increasingly pricing in this shift in quality.
Figure 1 reveals a striking message that is taken from the evolution of the spreads at the highest point of each of the past five market crises. In the cases of 2008 and 2011, the peaks of European high-yield spreads had surpassed those of the US by about 100 basis points. Since then, the inverse has happened, notably in 2015 (with the Chinese slowdown) and in 2020 (in spite of the European banks’ dividend turmoil). In 2022, as the rates shock started, both US and European spreads topped at about the same value, with Europe demonstrating slightly more resilience.
Figure 1: Europe’s strengthening: maximum daily high-yield spreads in periods of turmoil
Source: Bloomberg, LOIM.
Is the quality of European spreads being challenged?
The past three market shocks could have been challenged by Federal Reserve (Fed) and European Central Bank’s (ECB’s) interest-rate hikes. But with the Fed tightening more aggressively that the ECB, and for a longer period of time, European spreads are still more creditworthy, according to ratings agencies.
Figure 2 provides a measure of that evolution, showing Moody’s forecasts of the expected default rates per currency zone. The numbers speak for themselves: European defaults are expected to increase by 1% until 2024, while US defaults should gain about 2.5%, with a final default rate of 5.8% – which is twice today’s value.
This mirrors our understanding of the situation, especially following the US regional-banks crisis: with more elevated banking risk in the US and a higher sensitivity to commodities (the asset class that has posted the lowest returns this year), US credit does not seem a defensive play. Also, the technology complex is made up of cash-rich companies which are therefore underrepresented in credit indices.
Figure 2: On firmer ground? European speculative-grade default rates versus US
Source: Bloomberg, LOIM.
A cloudy outlook
While figure 2 reflects a situation that will be later revised as we discover the extent of the intensity of defaults, we also need to understand how this ratings revision is set to unfold. When looking at ratings drifts (upgrades minus downgrades) and ratings-outlook drifts, we see weakness in the US, and this is the message of figure 3. Europe is clearly showing more resilience then the US, where the ratings drift from Moody’s has showed a continuous deterioration since November 2021.
While we believe we are currently in a credit sweet spot, driven by factors including positive sentiment and a stable and active primary market, we see investors adding to credit exposures and positioning becoming long. We would advise a more discriminating approach here, with a preference for the more defensive European credit over the US, especially when considering the valuations of both markets.
Figure 3. Moody’s rating drift and outlook drift in the US and the EU
Source: ONS, Bank of England, LOIM at June 2023.
Different quality, same price
If the difference in quality should seem obvious now, it is not reflected in pricing, in our view. Figure 3 shows these consistent valuations by comparing US and European credit spreads in the investment-grade and high-yield markets. If US credit looked expensive until the beginning of the 2022 rates shock, it has since been largely repriced and become cheaper relative to Europe. As the March banking crisis hit, this situation reversed, leading both credit markets to look equally expensive. Now we have reached a point when – according to our metrics – both regions are similarly priced, and yet we see the previously mentioned difference in terms of credit quality and ratings drift. US and European credit trade at the same price, but do not offer the same quality.
Figure 3. US and European credit spreads: relative cheapness
Source: Bloomberg, LOIM.
By factoring in the overall yield rather than focusing on the pure spread, and hedging back to the reference currency, European credit appears to offer even better value *see figure 4). This is quite counterintuitive to the economic backdrop and provides potential opportunities, in our view.
Figure 4. US and European yield-to-worst: relative cheapness
What is happening on a macro level?
The macro situation is likely responsible for one of the key triggers that has improved the relative attractiveness of European credit. Spreads are cyclical, and a relative deterioration between the two economic zones could explain a preference for one over the other.
Figure 5 shows a comparison between our relative growth nowcasters (US versus Eurozone) compared with transatlantic high-yield spreads. The message from that chart is not supportive (relatively speaking) for US credit. Growth conditions in the US have deteriorated much more that in the Eurozone, according to our indicator. This is consistent, as mentioned above, with the ratings deterioration anticipated by Moody’s, and the situation has historically been associated with higher spreads in the US than in Europe. But that is currently not the case.
The fact the market has not yet priced in this difference makes the current situation a potentially compelling entry point, in our view: better quality in Europe and a relative macro deterioration in the US, both of which are not accurately reflected in credit spreads.
Figure 5. LOIM Growth nowcasters’ difference vs transatlantic credit spreads
Source: Bloomberg, LOIM.
| Simply put, where US equities look preferable to Europe, the opposite applies in credit markets. European credit shows greater resilience and better creditworthiness than its US counterpart. |
Macro/nowcasting corner
The most recent evolution of our proprietary nowcasting indicators for global growth, global inflation surprises and global monetary policy surprises designed to track the recent progression of macroeconomic factors driving the markets.
Our nowcasting indicators currently show:
- Our growth indicator globally held steady over the week. The Eurozone’s European Commission survey is, however, pointing to a lower growth situation in the Eurozone – at last
- The inflation normalisation goes on and our nowcasting indicator points a stabilisation period now
- Our indicator marginally breached its lower threshold of 45% on 15 June and has remained there since: the perfect image of what markets are trying to price, marginally higher rates, with the temptation of cuts entering into 2024
World growth nowcaster: long-term (left) and recent evolution (right)
World inflation nowcaster: long-term (left) and recent evolution (right)
World monetary policy nowcaster: long-term (left) and recent evolution (right)
Reading note: LOIM's nowcasting indicators gather economic indicators in a point-in-time fashion to measure the probability of a given macroeconomic risk - growth, inflation and monetary policy surprises. The Nowcaster ranges from 0% (low growth, low inflation and dovish monetary policy) to 100% (high growth, high inflation and hawkish monetary policy).
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