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The 2014 All-Europe Fixed-Income Research Team
Market fundamentals have improved, but deflation fears cloud the fixed-income outlook.
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Six years after the outbreak of the global financial crisis and four years after Europe’s debt crisis erupted, signs are growing that the region’s economy — and its fixed-income market — are on the mend.
Economic output in the 18-nation euro area expanded by 0.3 percent in the fourth quarter of 2013, compared with the previous period, marking the third straight quarter of positive growth and slightly faster than many economists had expected. Other indicators are also sending positive signals. Factory output in January grew faster than economists had forecast, and economic confidence increased for a ninth straight month.
The modest recovery, coupled with forecasts that growth will run at a pace of about 1 percent this year, has raised hopes that the bloc has fully escaped the long recession and existential currency crisis that gripped the region from the middle of 2011 to early last year.
Yet plenty of risks remain. Inflation is running at dangerously low levels, raising the threat that the euro area could fall into a deflationary spell reminiscent of Japan’s experience for much of the past two decades. And European banks will undergo a rigorous balance-sheet assessment and stress test this year, a process that aims to finally restore the sector to health but that could reveal some costly skeletons.
“The so-called idiosyncratic periphery risk has diminished a lot over the past 18 months,” says Michael Maras, head of global credit and emerging-markets fixed-income research at Bank of America Merrill Lynch in London. “The major risk for Europe is deflation. The European Union has to be vigilant that they don’t kill off the potential growth recovery that, for example, European equity markets have already anticipated.”
Notwithstanding the uncertainty, Maras believes the fixed-income market may help bolster the economy. “Our view is that there is a lot of long-term structural demand for fixed-income products which will continue to support those markets.” He cites two 100-year bonds sold in January by French utility Électricité de France. The offerings, the first such issues in Europe in almost three years, raised a total of $2.9 billion. “They were hugely oversubscribed and popped up 3 or 4 points at the opening of their trading,” says Maras. “That to me says that the long-term structural demand for fixed-income products is still there, and that will be one of the things that will smooth some of the expected volatility.”
Navigating these conflicting influences will challenge investors in 2014. They look to sell-side research for insight and guidance, and when it comes to European fixed-income securities, no firm does a better job than J.P. Morgan, according to Institutional Investor’s All-Europe Fixed-Income Research Team. The U.S. bank occupies the top slot for a fourth straight year, garnering 19 total team positions, two more than last year. Bank of America Merrill Lynch climbs from third place to second, capturing 15 total team positions, an increase of two from a year ago.
Barclays goes down one notch to third place, with 13 team positions, one fewer than last year. Deutsche Bank keeps the fourth slot and Morgan Stanley retains the fifth, each maintaining last year’s total team positions of 12 and 7, respectively.
Although they rank lower than BofA Merrill, Barclays, Deutsche Bank and Morgan Stanley all do better in terms of first-team positions, with eight, five and one, respectively.
The results reflect the views of almost 800 analysts and portfolio managers at some 380 institutions worldwide that manage about $6.4 trillion in European fixed-income assets.
Europe’s fixed-income market has rallied ever since European Central Bank president Mario Draghi promised to do “whatever it takes” to save the euro back in July 2012. Ten-year government bonds of Greece, Ireland, Portugal and Spain, which turned to the EU and International Monetary Fund for bailout programs, last year posted double-digit total returns. Hungary, Italy and Slovenia, which also face significant debt and banking troubles, posted single-digit returns of at least 7 percent.
Investors have been more than ready to participate in the turnaround. Cumulative net inflows into EU fixed-income funds and exchange-traded funds rose to €8.5 billion ($11.7 billion) last year from €5.4 billion in 2012, according to Deutsche Bank.
Still, the signs of an emerging economic healing for the region may not be enough to persuade portfolio managers and analysts that the recovery will have legs. In addition to worries about possible deflation, analysts cite a risk of a possible slowdown in economic reform in countries like France and Italy.
“Whether this is a sustainable recovery for the next three or five years, I am not yet there,” says Marcel Cassard, London-based global head of macro and fixed-income research at Deutsche Bank. “I think growth in Europe will remain too low for my comfort level. I don’t think enough is being done to raise the potential output in places like Italy.”
Inflation in the euro area slowed to 0.7 percent in January and has been under 1 percent since October. That’s significantly below the ECB’s target of below, but close to, 2 percent. Draghi sought to dispel concerns about deflation in his monthly news conference in Frankfurt in early February. The euro zone is “experiencing a prolonged period of low inflation,” he acknowledged, but added, “we have to dispense with the question, is there deflation? The answer is no.” Yet the low level of inflation keeps deflation talk alive, as well as speculation about a cut in the ECB’s lending rate, which currently stands at a record low of 0.25 percent.
Ajay Rajadhyaksha, New York–based co-head of fixed-income, commodities and currencies research at Barclays, says clients are still concerned about debt levels in southern Europe. “In some countries those debt burdens have continued to worsen,” he says. “One of the ways you can make a debt burden worse is if you deflate. And the way out of it, realistically, would be for significant inflation to pick up in the euro zone. That has not happened. And this lack of inflation is one worry that investors are focused on in Europe right now.”
The top European fixed-income research departments plan few, if any, new additions to their teams in the next year.
BofA Merrill intends to sharpen its focus on the high-yield sector, emerging-markets corporate credits, hybrid instruments and new contingent convertible debt instruments — know as CoCos — in the financial sector, according to Maras. The department has added two analysts to bolster its high-yield securities squad, which will add coverage of 43 high-yield corporate issuers in developed Europe and another 18 such credits in European emerging markets this year.
The expansion is partly a result of a Standard & Poor’s report last year that said about 200 companies in Europe were assigned ratings for the first time in 2013. The number of high-yield issuers in Europe last year grew to 350 from 250 a year earlier, Maras estimates. “The developments in Europe, the deleveraging of the banking system, are going to force more issuers to come to public markets and eventually move to a U.S. funding model where debt capital markets are disintermediating the banking system,” he says.
Deutsche Bank recruited several analysts to its European fixed-income research team in the past few years to focus on the troubled economies of Greece, Italy and Spain as well as on the financial sector. “That paid off and allowed us to be much less negative than a lot of other banks on the European breakup story — on the ability of policymakers to step in at the last minute possibly to prevent a breakup,” says Cassard.
As the debt crisis has eased, the department has shifted its attention away from those peripheral countries and toward core euro members such as France, Germany and Italy. “We shifted more emphasis on understanding what was structural, what was cyclical, where we were seeing signs of risks that inflation concerns could become entrenched,” adds Cassard.
Gilles Moec, co-head of European economic research at Deutsche, says the bank’s fixed-income analysts were “among the most constructive on Europe” throughout the debt crisis. “We never joined the camp of those who questioned the very existence of the euro zone,” notes the London-based Moec, who with Mark Wall leads the No. 1 team in Economics. “At times investors listened to us with quite a lot of skepticism. But it’s been much easier to talk up Europe, so to speak, over the last year.”
A further change at Deutsche Bank in light of the easing of the debt crisis has been the integration of foreign exchange and rates research in Europe last year. “There are such strong linkages between the European rates market and foreign exchange now, and the complexity of the European rates market is much higher today than it was a few years ago,” asserts Muhammad Umar Bilal Hafeez, the bank’s global head of foreign exchange research.
London-based Hafeez and his crew, who come in first in Currency & Foreign Exchange, launched a new research publication late last year, “The Week in FX,” which goes out every Friday and includes research from the previous five days to help clients better absorb the latest data and market trends.
Hafeez believes the euro is likely to weaken this year as a result of talk — and possible action as soon as this month — of the ECB cutting interest rates even as the Fed steadily reduces bond purchases.
Although stance on the euro, Hafeez is bullish on the British pound, which he prefers to play against the Canadian dollar. He also likes the U.S. dollar and expects the Swiss franc to weaken this year “as people start to unwind their safe-haven trades that were put on in the context of the European crisis.”
James Reid, Deutsche Bank’s London-based global head of the fundamental credit strategy group, which ranks first in the Investment-Grade, High-Yield and General Strategy categories, expects European inflation to remain low “in the foreseeable future,” setting the stage for a “decent year” in fixed income in 2014. “Added to that, there is a chance that the ECB will end up buying assets as we move toward the second half,” he says. “If they do buy assets, that will probably help the fixed-income market further in Europe.”
Reid recommends investors remain in high-yield and financials “just to get the extra yield and spread.”
At Barclays, Rajadhyaksha says, the European fixed-income analysts devote less time to southern European countries because of the easing of the debt crisis and more resources to U.K. and German economics as well as traditional ECB watching. “The focus was far more on the macro two years ago, and now we have moved to the micro as the market has stopped worrying about the macro overwhelming the micro,” he explains.
Stephen Dulake, London-based head of international credit research at J.P. Morgan — whose team, co-led with Jan Loeys, takes second place in General Strategy — says he expects investors in Europe to be more interested in sector and credit selection and less concerned about macroeconomic issues. “Over the past year, in general, the credit market trade has been a beta one,” he says. “With the general decline in risk premiums now to the extent that a new macro landscape to a large degree is priced in, what you will see is much more discrimination at the single-company level or single-credit level.”
Europe’s banking industry is one of the key sectors that is drawing attention among fixed-income investors as banks cut lending amid pressure from an unprecedented asset-quality review, or AQR, and a new round of bank stress tests by the ECB, ahead of its assumption of responsibility for banking supervision in Europe at the end of this year. The ECB will publish the results of the two exercises in October. Its data show that banks trimmed the size of their balance sheets significantly at the end of last year in preparation for the review.
Jacqueline Ineke, Zurich-based head of European financials credit research at Morgan Stanley, whose London-based Investment-Grade Banking & Financial Services team ranks first in the sector, expects a further rally of bank stocks and bonds this year. “We are overweight on bank credit this year, and we were overweight last year,” she says. “Comparing banks to two or three years ago, the capital is significantly increased; provisions have significantly increased; earnings have become more consistent, much less volatile; and the outlook is much better just as a background in terms of the European economy.”
Not that the improvement will reduce the workload for Ineke and her colleagues. The analyst expects banks to raise a substantial amount of debt this year to meet capital requirements. The supply will include a large quantity of contingent convertible debt, which she forecasts will grow to at least €200 billion in the next few years from the current €10 billion to €15 billion.
According to Ineke, British banks, which underwent a capital review last year by the Bank of England’s Prudential Regulatory Authority, and Swiss lenders, which already meet high capital requirements set by their regulator, will emerge as the winners of the AQR. The losers may include banks in Italy, where the economy is ailing and asset quality is “notoriously very weak,” she adds.
The high-yield sector is also drawing bullish investor expectations for issuance. David Caldana, head of technology, media and telecommunications credit research at J.P. Morgan in London, says a “much greater diversity” of high-yield issuers previously funded by loans was entering the fixed-income market. Those placements include last year’s instruments sold by Romanian cable and satellite operator RCS & RDS; Oberthur Technologies, a French smartcard maker; and Italian computer software provider TeamSystem, says Caldana, whose team, co-run with Andrew Webb, ranks first in High-Yield Technology, Media and Telecommunications.
“High-yield new issuance has really been a big focus in the last year in particular, so you’ve got a lot of corporate analysts spending time educating investors on new companies coming to market,” he adds. “So there has been a shift in the way that we as analysts allocate our time.”
Saul Doctor, who along with Rishad Ahluwalia captains the J.P. Morgan Credit Derivatives team that ranks first in its category, says the top challenge for investors this year is to prepare for an overhaul of credit derivatives contracts by the International Swaps and Derivatives Association. The changes to rules on credit default swaps, which aim to overcome flaws in the insurance contracts that were exposed by the sovereign debt crisis, are expected to take effect in September. Under the changes, the list of credit events that can lead to a payout will also include bankruptcy, failure to pay, restructuring and so-called bail-ins — when a borrower’s creditors are forced to contribute to its financial rescue.
Doctor says investor demand has shifted in the past few years away from single-name CDS and toward credit derivative index products and options. “The iBoxx Total Return Swap is now becoming mainstream as investors engage with products that give macro exposure to credit,” says Doctor, who is based in London. “This has been at the expense of the single-name CDS product, which has been less prevalent as investors are less concerned over idiosyncratic risk and single-name defaults.” • •