- France: four different (and uncertain) outcomes
French President Emmanuel Macron's shock decision to call a snap general election at the end of this month after a severe setback during the European election might stir up old sentiment with concerns of a stronger populist grip in Europe and the impact that might have on trade, environment, immigration and fiscal policies, among other issues.
Current polls have the National Rally (RN) leading (on 33-35%), which would likely result in c.220-260 seats in their projections followed by the new left-wing alliance, the Front Populaire (26-29% if polled as a group, c.165-195 seats) and the president’s coalition (19-22%, c.85-115 seats). LR is expected to get 6-7% of votes, ie, between 30 and 45 seats in the 577-seat Parliament.
The key risk is not a Frexit scenario, as in early 2017, but further fiscal slippage without any scope for corrective action in the event of a hung parliament or an outright majority for the National Rally. The French general government deficit reached 5.5% of GDP last year (and the 2024/2025 targets are 5.1% and 4.1% of GDP as of late), which puts France on the Excessive Deficit Procedure list and, according to new EU rules that will kick in next year, France will need to make a 0.5% structural deficit adjustment per year until the overall deficit comes in below 3%.
From a macro/fiscal perspective, France has: i) a Debt-to-GDP ratio of 111% (end-2023), up from 97% in 2019, the highest increase in pre vs. post Covid levels among big-EU countries; even its private sector indebtedness (as a percentage of GDI) is well above that of other countries.
France's corporate debt-to-GDP ratio is one of the highest in the world, standing at 150.4%. French credits comprise 21% of the Euro IG credit market, the largest country weight. In three sectors (banks, insurance, utilities) France is the biggest issuer in the EUR iBoxx IG credit benchmark (22%, 27% and 23% weight, respectively). There is a greater representation of French corporates in the IG than HY segment (21% vs. 16% in iBoxx index).
France’s risk premium is at its highest level since November 2012. The relative OAT-Bund spread is now in the mid-70s area, with a potential target around +90bp, as the +90-100bp range would be equivalent to the 2017 presidential election peak of +80bp when adjusting for today's French fundamentals and ratings. In credit markets, financials have underperformed NFCs so far. Contagion has been moderated up to now, as a wait-and-see approach is predominant among investors who did not overreact to recent volatility spikes, and they are not taking large positions early ahead of the vote, especially as this will be a two-round election.
The consensus view (one that is potentially overly complacent) is that the situation ultimately provides a buying opportunity. European investors are no strangers to political risk. They may assume that this situation will be resolved in the same way as with Syriza in Greece, M5S in Italy, or even Liz Truss in the UK – with populist economic rhetoric being restrained when it comes to actually governing and facing the realities of international bond markets and the European fiscal framework. We expect French international corporates with significant overseas revenue to outperform purely domestic issuers, where we could see a more persistent premium.
We have to acknowledge that the market has been extremely resilient in the last 18 months, and our base-case scenario is that the market will be able to navigate these waters without panicking. The technicals are still extremely strong, with further inflows into euro investment grade funds that need to be put to work, and primary markets soon slowing for the summer, UEFA Euro 2024, and the Olympic Games.
- Central Banks: monetary policy divergence debate continues on
Central Banks: The monetary policy divergence debate will continue, as it is agreed that the ECB cannot front-run the Fed too much, so the US rate trajectory has a direct influence on its European peer. Regarding the ECB, the absence of guidance about future moves highlights that the GC remains deeply uncertain about the pace of disinflation, particularly domestic inflation, with the GC remaining non-committal and sticking to its data-dependent meeting-by-meeting mantra.
Fed-wise, solid growth coupled with a lack of guarantees so far that the downtrend in inflation will resume – do not justify a rush to cut interest rates, in our view. Having said this, we have seen recent softness in US macro data (retail sales, home sales, weekly claims above the 230k mark) that merits attention. In our view, there are clear signs that growth in economic activity is moderating, reducing the risk of overheating. This should keep market expectations centred on policy rate cuts rather than rate hikes. We need to monitor whether, at some point, the US economy could begin to slow much faster than market consensus – and the Fed – expects.
Commercial real estate (CRE) has remained a dominant issue, with sub-segments such as apartments and industrial seeing strength, while offices continue to see broad weakness. Negative headlines about CRE continue to hit the screens on a regular basis. There is c. USD700bn of non-agency CMBS outstanding and another USD3trn of commercial mortgages on bank balance sheets. The share of delinquent office loans packaged into a common type of commercial mortgage-backed security reached 6.4% in April, the highest since June 2018, according to Moody’s. Vacancy rates nationally sat at 19.8% at the end of the first quarter of 2024, according to Moody's, c.5% above pre-COVID levels, and are set to rise further.
US banks provide over half of the debt financing to the nearly USD6trn CRE market and, according to Moody’s, a number of domestic banks still have notable concentrations in loans with near-term maturities, low debt-service coverage ratios (DSCRs) and high LTVs, as well as in the office and construction segments. Material downside risk would emerge for some loans if interest rates remain at current levels or increase through 2026.
- Our credit stance: This is still a carry-friendly, ‘buy-the-dips’ market
Despite the recent and ongoing headlines about France, our view is that credit will remain unusually non-volatile with shallow dips and we prefer carry over spread duration, with exposure to deleveraging sectors. Macro conditions are currently conducive to an unusual lack of volatility.
Investors are now comfortable with the macro picture and not particularly worried about a US recession, as it is hard to see meaningful risk scenarios where anything will “break” in 2024.
Credit markets have taken the repricing of central bank policy expectations in their stride in 1H24, pushing spreads back towards the 2021 policy-induced tights. At such rich valuations, the investment case for credit rests on this ‘not too hot – not too cold’ environment holding, while the disinflation process plays out. All told, we are getting used to the idea that spreads could remain tight for a while longer, until either there’s conclusive proof that the soft-landing narrative is invalid, or there’s a significant external shock.
High all-in yields continue to be a compelling proposal, while credit risk has moderated as the economy has not faltered. For spread widening, we think the catalyst would come from outside the credit space – e.g. growth risk, rates risk, equity pullback, geopolitics, etc. As such, strong demand has surfaced to buy dips in the event of any spread widening. Moreover, July tends to be one of the strongest months of the year for credit market performance as the summer supply lull takes hold. Median July IG spread tightening has been 6bp since 2000, and 11bp since 2010, the strongest month in the year. Median July HY spread tightening has been 11bp since 2000, the second-strongest month in the year.
- DM Credit markets: our positioning
French blues opens a new window of opportunity for senior financial debts, but in the medium term we are warming to senior NFCs debt
We are well aware that the banking sector is supported by strong fundamentals and is still rewarding; we may have at least one more quarter of NII benefits from rates for some banks, but we consider that we are close to the peak in terms of pick-up potential and there are some downside risks in a higher-for-longer scenario on rates (corporate defaults, inverted curves, real estate weakness, France rating downgrade) that might affect the sector's appeal.
EUR banks are also exposed to a “faster-than-expected” rate-cutting scenario further down the line if disinflation in Europe reaccelerates in late 2024 and/or the macro picture weakens unexpectedly, in addition to further negative noise from US banks/CRE, where we believe that situation is likely to worsen in the months ahead, particularly in the case of weaker-than-expected performance from the US economy.
We still see room in financials subordinated debt, we prefer AT1s vs. Tier 2s
In the subordinated space and due to the compressed NFC hybrid spreads, we still see value in financials subordinated debt. AT1s have made a remarkable comeback post Credit Suisse. Our financial analysts consider that extension risk should generally remain low, with the market also supported by a pick-up in tender activity for AT1s. EUR AT1s still screen as wide to EURLT2s and also screen wide to EUR Bs. Furthermore, given the resurgence in idiosyncratic risk in HY – which arguably is unlikely to go away given the continued high refinancing costs – we find AT1s compelling as an alternative to EUR Bs. Moreover, EUR AT1s that can be called about one year from now look like an interesting proposal, as rates at that time will be markedly lower, as long as market conditions remain favourable.
Long EUR IG NFCs vs. HY
Credit markets look too compressed and the relative supply trends should favour EUR IG. We see wider spreads in HY towards the end of the year, with economic growth moderating, government bond yields lower, and dispersion of earnings growing. Moreover, although the ECB delivered its first rate cut of the cycle a few weeks ago, as expected, there is growing debate that the path lower (for rates) could take longer; the longer rates stay high, the greater the risk that defaults could become more persistent.
Strong upgrade of credit ratings in 2024 within the IG universe, while in the HY segment there is the opposite trend (the net upgrade ratio is steady at 0.7x in 2024). However, so far this has not really impacted the strong demand from investors for the asset class, due to the current low-volatility market conditions.
EUR IG NFCs: BBBs look too tight vs. single-As
Spreads continue to compress within IG. The BBB versus A industrial basis is the narrowest since 2007. BBB industrials are trading only 39bp wider than A industrials. The basis has narrowed by 10bp year-to-date and is at the tightest level since mid-2007, when the IG Industrials index was around 100bp, vs. 85bp now.
Corporate hybrids look expensive vs. Tier 2s & senior NFCs, but risk-reward is still attractive
In the US and Europe, corporate hybrids have outperformed year to date within the credit universe, achieving material senior sub-spread compression in a context of solid demand and manageable supply. We believe that this solid momentum for corporate hybrids reflects current market dynamics, but also more structural considerations for the instrument that leads to compression in the senior-sub spread differential. Overall, beyond absolute valuation levels, we consider the risk-reward offered by corporate hybrids remains relatively attractive, with most of the asset class offering 'HY-like' returns on robust IG names.
- Risks to our view
Risks: a) Geopolitics and US elections; b) France/a return of elevated government debt levels as a narrative and, as a consequence, fragmentation risks, and arguably also market pricing thereof, could increase; c) an alternate scenario to a soft/landing, where the US macro picture deviates from the soft landing thesis – either because there is a break in the US economy or because persistent inflation causes the Fed to keep rates high for a prolonged time period or to raise them further – thus raising fears of an eventual hard landing in 2025/2026; d) high equity valuations. A strong uptick in defence and AI-related capex has helped US earnings, while immigration growth supported US GDP in 2023 and into 2024. Heightened concentration and high valuations in equity markets, notably in the United States, indicate scope for more volatility and the potential for a market correction.