Août 2015 – Crédit – Le crédit européen, une valeur refuge?

Since the onset of the financial crisis, Europe has always been a driver of downside risks if not the major downside risk to financial markets and investor risk aversion. It is therefore interesting to analyze the recent market turbulence which is now mainly driven by exogenous factors – Fed decision, EM, commodity prices – while domestic European drivers are a source of stability. Such an inversion in the financial market dynamics is unprecedented in the current cycle and raises a few interesting questions: What makes European credit currently healthy and how sustainable is it? What are the downside risks to our view? Would any additional correction in European credit assets offer an attractive opportunity to add to our long positioning?

European domestic drivers remain positive for credit

After a few months creating market jitters, the Greek situation seems temporarily under control. The agreement between Greece and the EZ around a new program of structural reforms and fiscal discipline in exchange for €85bn of new funding has started to be implemented. The announcement of new general elections to be held on 20 September is expected to ensure a better execution of the program and create a backdrop for negotiating some form of official debt restructuring. All this was enough to put Greece off the radar screen in European markets and we don’t see it becoming a source of economic or financial stress again in the foreseeable future.

More importantly, our positive outlook for credit fundamentals continues to gain traction. The economic recovery is now well anchored in Europe with a decreasing divergence across the various countries – Greece being an exception. This cyclical upswing is magnified by the combination of three powerful forces: a competitive euro, falling energy prices and low interest rates. Add to the equation the continuing improvement in financial conditions and you get the favorable environment for credit fundamentals currently experienced by European corporates and financials. In this context, it is hard to see default rates pick up in the next few quarters in Europe despite our assessment that corporate actions, financial policies and financing terms in capital markets have all started to move towards the aggressive side.

Last, it is also worth noting that the ECB remains firmly on the easing side in its policy stance. Although it has not made the headlines recently with some new policy announcements, the size of its current QE program and its commitment to act further should financial conditions tighten in Europe should not be underestimated. As discussed many times here, we estimate that the ECB’s QE program will generate more than €400bn of excess liquidity to be deployed outside its list of eligible assets annually, thereby supporting the technical situation in European credit markets.

Downside risks from US rates, EM and commodities, but with limited impact

The current concerns around the timing, speed, extent and rationale for the future Fed hikes do not really create risk for Europe at the moment. What does create risks for European credit would be a significant selloff in US fixed income markets induced by such a policy move – as opposed to the move itself and its impact on corporate Europe’s financing costs. Similarly, the steep economic slowdown currently experienced by several EM countries not only reduces global growth expectations for the rest of 2015 and 2016, but it may also lead to tighter conditions in global financial markets. While the former is manageable given the current economic momentum in Europe, we regard the latter as a potentially more significant risk if contagion would spread to risk assets in DM. Last, we consider that the price action in many commodities markets could actually benefit to Europe. However, there is also a scenario where such turmoil – in particular in the oil & gas sector – could push US HY default rates meaningfully higher, create significant losses in US credit markets and reprice credit risk more globally, including in Europe.

As discussed, none of those risk factors are Europe-driven. In actual fact, they have very little to do with Europe. Importantly, the potential for future second-round effects on Europe’s economy and corporate profits is very limited at this stage. For European credit markets, the transmission mechanisms of those exogenous risks lie with risk aversion and major outflows – especially from global funds impacted in their US credit and/or EM allocations. At this stage, our assessment remains that the momentum of credit fundamentals in Europe and the ECB policy stance would mitigate such downside risks. As a result, we would see any significant price correction in European credit markets driven by those factors as an opportunity to add to our long positioning.