An Ocean of Difference

‘Copy and paste’ your U.S. inflation outlook onto Europe and you may miss the opportunity in core European bonds.

The senior leadership of Neuberger Berman’s fixed income team recently gathered in London for our annual summit. It was a great opportunity to catch up in person with portfolio management colleagues in our London, Paris, Hague and Milan offices, but also a good time to take the pulse of the European bond markets.

Bonds are back globally, but the theme is especially resonant in Europe, where entire core government yield curves spent time below zero and the German 10-year yield was negative for almost three years. The attractiveness of Europe’s traditional, plain-vanilla investment-grade market is becoming more apparent to foreign investors: While the positive carry from hedging euros back into dollars has declined since 2022, it remains positive at 1.4%, bumping all-in yields up to the 4 – 5% level.

Here's why we think Europe’s core fixed income market is worth a look—and is perhaps even more attractive than investors currently perceive.

Departing From Consensus

As our most recent Fixed Income Investment Outlook explained, we favor the intermediate maturities on most yield curves. Again, the theme is especially pronounced in Europe.

Between two and five years, we estimate risk premia to be almost a whole percentage point, as high as they have ever been for eurozone bonds. It is also at these intermediate points that we have greatest confidence in those estimates because it is where we have the most confidence in our projections for inflation and European Central Bank policy.

That is important, because with these projections, we depart a little from the consensus.

While expectations of a U.S. Federal Reserve rate cut in June are now a distant memory, markets still assign more than 80% probability to a June cut from the ECB. We see much less market certainty about what happens beyond June, however, for two reasons.

First, there is commentary from ECB hawks such as Joachim Nagel. Last week he hinted at a move in June, but warned it “would not necessarily be followed by a series of rate cuts.”

Second, we believe there is a certain amount of “copy and paste” going on: taking views on U.S. inflation, which took another hit with last week’s Personal Consumption Expenditures data, and assuming they apply to the eurozone outlook.

We understand that view. Europe followed the U.S. with a three- to six-month lag during the run-up in inflation in 2022, and many expect to see the same again, with European inflation getting stickier over the coming months; however, we think the dynamics are now very different.

Is 2% in Sight?

While true that last week’s Purchasing Managers’ Index and GDP releases showed the U.S. economy cooling a little while Europe continues to recover, Europe’s expansion is being driven almost entirely by services, and European services growth tends to feed only weakly into European inflation.

Meanwhile, Europe has a healthy jobs market, but nothing like the supercharged hiring spree in the U.S. Wage deals being agreed to in Europe are not only generally lower than those seen on the other side of the Atlantic, but also are longer-term, locking in more labor-cost certainty.

Those wage dynamics point to the different nature of inflation in the U.S. and Europe. In the U.S., prices spiked largely because of pandemic-related, demand-side forces: high excess savings and the release of pent-up spending. In Europe, the chief cause was Ukraine-related, supply-side disruption in energy and food. Today, rising wages are keeping U.S. demand-pull inflation sticky, whereas supply-push inflation is easing in Europe.

Finally, we believe the base effects from last year’s inflation data are significantly more favorable over the next two quarters in Europe than they are in the U.S.

The current consensus is that eurozone core inflation, currently at 2.9%, will struggle to return to 2% before the end of the year. By contrast, for the reasons stated above, we believe that target could be hit soon after the summer.

In our view, that would give the ECB room to fit in four rate cuts during 2024 rather than the two for which the market is (only tentatively) priced. We believe the ECB has already agreed, internally, to cut in June.

‘Peripheral’ Tightening

If we think ECB rates are going to decline faster than the market expects, why did we express a neutral view on Italy and Spain versus an overweight view on core government bonds in our latest Fixed Income Investment Outlook?

The main reason is that, as fears of runaway inflation have eased, “peripheral” eurozone spreads have begun to trade in sympathy with credit spreads rather than rate expectations, resulting in substantial tightening this year. In our view, that means much of the good news we anticipate on inflation is already priced in, although we remain cautiously favorable toward Spain and Portugal.

Normalization

So, the consensus view favors European fixed income, and we think that view has merit. We simply embrace it more enthusiastically. In our view, investors have let themselves be distracted by sticky U.S. inflation dynamics that have limited relevance in Europe.

To be clear, our view does not depend on a dovish turn from the ECB. One hundred basis points of cuts this year would count as normalization after the hawkish, emergency stance necessary when inflation threatened to get out of control. A policy rate of 3% would put us in a normal range for a backdrop of inflation at 2% and growth at 1%.

Nonetheless, a “normalization” outlook is still more optimistic than the market’s—and therefore, in our view, it represents an opportunity.