By Yanick Loirat, PhD
While spreads have tightened within Europe’s periphery, that trend could continue in a soft-landing scenario.
As European inflation fears continue to cool, some investors are convinced that the European Central Bank (ECB) has completed its latest hiking cycle in line with a soft economic landing central scenario.
That outcome, in our view, could benefit bondholders aiming to profit from rolling down the yield curves in countries on Europe’s periphery, where grants and cheap loans – courtesy of the EU’s recovery fund (formerly the Recovery and Resilience Facility, or RRF) – may support economic growth without straining public budgets.
Here is a comparative snapshot, with each country’s recent 10-year spread (estimated ranges from Bloomberg observations) over the German BUND:
Italy (+170-180 bps). Italy has been under pressure for loosening its fiscal plans, delaying recovery fund implementation and ending the “Super Bonus 110%”, a housing tax credit designed to promote energy efficiency.
The removal of that credit will curb GDP, translating into a debt/GDP ratio of around 140% in coming years. Meanwhile, the country’s refunding needs could push up net bond supply, especially if Pandemic Emergency Purchase Program reinvestments draw to a close next year.
Spain (+95-105 bps). After a period of political uncertainty, Prime Minister Pedro Sanchez will retain his post with a fragile coalition. Meanwhile, inflation remained contained throughout the recent energy crisis, and a successful tourism season has boosted GDP.
Additionally, the country’s 2024 GDP should reflect the benefits of its recovery fund investments. Spain’s debt/GDP now stands at 110%, down 3% since in 2022, and net bond supply should be lower in 2024 than in 2023.
Greece (+115-125 bps). We believe the December 1 rating review by Fitch should merit the country’s reinstatement within investment-grade benchmarks. While the country’s debt/GDP still stands high, at 166%, it has fallen faster than its peers. Net bond supply is expected to decrease in 2024.
Portugal (+60-70 bps). Fitch and Moody’s recently upgraded the country’s rating to “A”, thanks to its primary surplus, peer-beating GDP and reasonable inflation.
But there is turbulence, too, as Prime Minister Antonia Costa recently resigned amid a corruption investigation. The former administration expected Portugal’s debt/GDP – now at 110% – to fall below 100% by the end of 2024, but that trajectory is now in doubt. Net bond supply is expected to fall next year.
While spreads have tightened within Europe’s periphery, we believe that trend could continue in a soft-landing scenario. Specifically, we think Spain and Greece appear to be best poised to benefit – potentially spelling good news for their bondholders.
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