3. The ECB cannot sustain its aggressive policies

Europe’s slowing macro backdrop likely means that the ECB’s hiking ambition is close to an end. With deposit rates soon to be at 3%, the cost of borrowing for the European consumer and small business is going to surge to levels not seen since the sovereign crisis and could have a considerable impact on European economies. Whether the ECB further raises interest rates with this in mind seems implausible in our view, but the bank has already signalled another 50bps rate hike in March, and a further 25bps in May and June. At this pace, Europe could very likely enter a period of stagnation and we maintain the view that the longer the ECB waits to cut the deposit rate to a more manageable level (i.e., <2%), the greater the rate cuts will have to be down the line.

The ECB also has aggressive plans to shrink its balance sheet via quantitative tightening (QT) which will mean €400-600bn of new government bond supply this year. This is the highest level of supply since the EU’s inception and makes us wary of the spread tightening potential for government spreads in Europe. Such a large volume of new debt will be difficult for the market to absorb, hence we are underweight most country spreads in our portfolios except for Germany.

Figure 3: Expected European government bond supply in 2023 is the highest since the EU’s inception

In November last year we outlined several reasons why we were constructive on the outlook for euro investment grade (IG) fixed income. The asset class had suffered its fair share of turbulence in 2022 driven by geopolitical shocks, extremely hawkish central banks, and general nervousness about the health of the European economy. With total returns reaching deeply negative territory*, it was fair to assume that the only way was up for the European bond-market after recording one of its worst ever performances in 2022.

Today, we maintain the view that the future looks bright for euro IG. Notwithstanding the very attractive valuations that exist, both in government and corporate bond markets, the inevitable continuation of Europe’s slowdown will create opportunities for the highest quality IG credits to perform. It will also mean a lot of upside potential for sovereign bonds in Europe, which continue to trade at historically cheap levels. Below we take a closer look at some of the key factors driving our positive outlook on euro IG in the months ahead.

^{* Source: Fidelity International. Euro Government and Euro Corporate Bonds, as measured by the ICE BofA Euro Government Index (EG00 Index) and ICE BofA Euro Corporate Index (ER00 Index) respectively, recorded negative total returns of -18.2% and -13.9% for the 12 months ending 31st December 2022.}
 

1. Inflation in Europe has peaked

In Europe, we remain of the view that inflation has peaked. If we exclude the series of transitory exogenous shocks the region suffered in 2020 due to Covid-19, and in 2022 due to Russia’s invasion of Ukraine, we can discount the argument that Europe is in a structurally higher inflation regime for a few reasons. Price pressures that had existed due to supply chain bottlenecks have normalised (chart 1), gas prices are well below their 2022 peak levels (chart 1), and there is a distinct lack of wage inflation in the Euro Area (chart 2). With these three dynamics at play, it is difficult to argue that inflation in Europe is lasting and will remain persistently above 2% going forward. 

Looking ahead, and absent a material run up in gas prices, we expect headline inflation in Europe to continue falling in 2023. This scenario should force the ECB to revise lower its inflation projections over the coming months. Although the path for core inflation is less certain, underlying indicators suggest that core HICP still has some momentum in the short term but could fall towards 4% by year-end. We maintain a long duration bias across our portfolios in line with our view that inflation should retrace to lower levels, which would result in a repricing of European government bond markets.

Figure 1: Container ship rates and commodity prices

^{Source: Fidelity International, Bloomberg, 31 December 2022. Data are indexed so that Jan 2021 = 100. Container shipping prices measured using WCIDSHLA Index and WCIDSHRO Index, respectively.}

Figure 2: Monthly negotiated wage growth (%)

^{Source: Fidelity International, Goldman Sachs Global Investment Research, Indeed, Haver Analytics, 31 December 2022.}

2. Growth momentum continues to slow

Global growth momentum has slowed in recent months and Europe is not immune to this trend. Though an industrial recession has been broadly avoided thanks to recent spells of warm weather and healthy storage supplies of natural gas, the big test for the European economy is likely to begin from Q223 onwards when the impact of exceedingly high interest rates becomes clearer. This is particularly relevant for Southern European economies where the consumer and service industries play a key role in GDP growth, and where the impact of materially higher costs of borrowing will be felt the most.

At a headline level we do not believe Europe will fall into a deep recession, nor do we expect global growth to enter a hard landing phase, however the aggressive hiking cycle in 2022 will likely cause growth and inflation in Europe to slow more than the ECB expects. Recognising this dynamic further validates our long duration bias, given that it will likely encourage a flight to quality. For corporates, having both China and the US in a less vulnerable economic position compared to Europe should ensure that the highest quality IG companies can still grow revenues and not be fatally impacted by the slowing demand globally.

^{Source: Fidelity International, BofA Research, 16th December 2022. Shown values for 2022 are expected values only.}

4. Flat curves present attractive investment opportunities

In our previous piece we flagged the attractiveness of curves in Europe given the extreme repricing observed in 2022. Today, German and swap curves remain at or near extreme flatness versus history and offer attractive investment opportunities. Once the ECB embarks on its sizeable QT programme and the European bond market is hit with a significant volume of new supply, there is a lot of room for a re-steepening of the yield curve. This dynamic should impact the long end of the curve the most, and we maintain a steepener position in our portfolios to benefit from the anticipated repricing.

5. Higher sovereign yields should encourage inflows

Yields on European government bonds continue to look enticing at current levels. Not only should the safety of government bonds in Europe encourage inflows, but for the first time in a decade investors truly benefit from the concept of "carry" in euro IG. Outright spreads and yields are so high that they act as a good cushion against near term volatility. As we anticipate a flight to quality and demand from investors looking to protect themselves from the slowing environment in Europe, the total return potential for euro IG sovereign bonds looks compelling.

6. Euro IG credit remains cheap on all metrics

The value proposition for euro IG credit remains attractive both on an absolute and relative basis. Spreads for the asset class currently price in a lot of bad news and remain cheap versus history, while higher yields make the risk-reward of euro IG relative to other asset classes and regions increasingly compelling. From a corporate health perspective, euro IG fundamentals are holding steady for now, however we can expect to see some degradation in quality of certain sectors and names as the impact of higher interest rates weigh on corporates. This year will continue to be about selecting the highest quality companies with strong liquidity positions and healthy balance sheets, as well as those that are likely to benefit from fiscal support.

Figure 4: Euro IG spreads compensate for the risk of recession 

^{Source: Fidelity International, Bloomberg, 31 December 2022; S&P LCD, UBS Research estimates, 14 October 2022.}

Figure 5: Euro IG valuations look attractive on all metrics

^{Source: Fidelity International, ICE BofA Euro Corporate Bond Index (ER00 Index), 31 December 2022.} 

Our offering in the euro investment grade space

The case for high quality fixed income assets will remain strong in 2023. Given the valuation backdrop in euro investment grade especially, we think there is a lot of upside potential for the asset class over the coming months. Fidelity’s euro investment grade product range offers three products to suit investors with different investment horizons and different risk-return profiles.

The Fidelity Funds - Euro Bond fund encompasses the whole investment grade universe, including government and corporate bonds, as well as utilising up to 30% out-of-index exposure to non-EUR denominated paper, crossover names, and some emerging market issuers.

The Fidelity Funds - Euro Short Term Bond fund has a more defensive return profile as it invests in corporate and government bonds with a maturity less than five years. Similar to the flagship Euro Bond, it can include up to 30% out-of-index strategies.

The Fidelity Funds - Euro Corporate Bond fund focuses on corporate bond issuance from high quality companies.

All three strategies implement an active, high-conviction, research-driven investment approach.

^{Source: Fidelity International, FF - Euro Bond Fund Y-ACC-EUR Share Class, net of fees as of 31st January 2023. Reference index is the ICE BofA Euro Large Cap Index (EMUL Index). Ongoing charges of 0.64% apply to the fund, basis Nav-Nav with gross income reinvested. For all investment restrictions applicable to the fund(s) referenced in this presentation please refer to the Prospectus and Key Information Document (KID) which can be obtained from Fidelity, online here: Euro Bond Fund Y-ACC-EUR | LU0346390197 | Rentenfonds (fidelity.de)}

^{Source: Fidelity International, FF - Euro Short Term Bond Fund Y-ACC-EUR Share Class, net of fees as of 31st January 2023. Reference index is the ICE BofA 1-3 Year Euro Broad Market Index (EMU1 Index). Ongoing charges of 0.48% apply to the fund, basis Nav-Nav with gross income reinvested. For all investment restrictions applicable to the fund(s) referenced in this presentation please refer to the Prospectus and Key Information Document (KID) which can be obtained from Fidelity, online here: Euro Short Term Bond Fund Y-ACC-EUR | LU0346393704 | Rentenfonds (fidelity.de)}

^{Source: Fidelity International, FF - Euro Corporate Bond Fund Y-ACC-EUR Share Class, net of fees as of 31st January 2023. Reference index is the ICE BofA Euro Corporate Index (ER00 Index). Ongoing charges of 0.65% apply to the fund, basis Nav-Nav with gross income reinvested. For all investment restrictions applicable to the fund(s) referenced in this presentation please refer to the Prospectus and Key Information Document (KID) which can be obtained from Fidelity, online here: Euro Corporate Bond Fund Y-ACC-EUR | LU0370787359 | Rentenfonds (fidelity.de)}

Past performance does not predict future returns. The funds returns may increase or decrease as a result of currency fluctuations. Fidelity Funds “FF” is an open-ended investment company (UCITS) established in Luxembourg with different classes of shares.

Rolling 12-month returns (net of fees, %)

^{Source: Fidelity International, FF - Euro Bond Fund Y-ACC-EUR Share Class, net of fees as of 31st January 2023. Reference index is the ICE BofA Euro Large Cap Index (EMUL Index). Ongoing charges of 0.64% apply to the fund, basis Nav-Nav with gross income reinvested. For all investment restrictions applicable to the fund(s) referenced in this presentation please refer to the Prospectus and Key Information Document (KID) which can be obtained from Fidelity, online here: Euro Bond Fund Y-ACC-EUR | LU0346390197 | Rentenfonds (fidelity.de)}

^{Source: Fidelity International, FF - Euro Short Term Bond Fund Y-ACC-EUR Share Class, net of fees as of 31st January 2023. Reference index is the ICE BofA 1-3 Year Euro Broad Market Index (EMU1 Index). Ongoing charges of 0.48% apply to the fund, basis Nav-Nav with gross income reinvested. For all investment restrictions applicable to the fund(s) referenced in this presentation please refer to the Prospectus and Key Information Document (KID) which can be obtained from Fidelity, online here: Euro Short Term Bond Fund Y-ACC-EUR | LU0346393704 | Rentenfonds (fidelity.de)}

^{Source: Fidelity International, FF - Euro Corporate Bond Fund Y-ACC-EUR Share Class, net of fees as of 31st January 2023. Reference index is the ICE BofA Euro Corporate Index (ER00 Index). Ongoing charges of 0.65% apply to the fund, basis Nav-Nav with gross income reinvested. For all investment restrictions applicable to the fund(s) referenced in this presentation please refer to the Prospectus and Key Information Document (KID) which can be obtained from Fidelity, online here: Euro Corporate Bond Fund Y-ACC-EUR | LU0370787359 | Rentenfonds (fidelity.de)}

Past performance does not predict future returns. The funds returns may increase or decrease as a result of currency fluctuations. Fidelity Funds “FF” is an open-ended investment company (UCITS) established in Luxembourg with different classes of shares.

SFDR Article 8 compliance information

These funds seek to achieve their investment objectives while promoting, among other characteristics, environmental or social characteristics, or a combination of those characteristics. The criteria for this approach are set out below:

• The Investment Manager considers a wide range of environmental and social characteristics on an ongoing basis for fund as set out below or in fund’s investment objective, but the Investment Manager has the discretion to implement enhanced, stricter sustainable requirements and exclusions (in addition to the firm wide exclusions list) from time to time.
• A minimum of 50% of a fund’s net assets are invested in securities with favourable ESG characteristics. Favourable ESG characteristics are established by reference to ESG ratings provided by external agencies or Fidelity Sustainability Ratings.
• The norms-based screening includes issuers which the Investment Manager considers have failed to conduct their business in accordance with accepted international norms, including as set out in the United Nations Global Compact. Through the investment management process, the Investment Manager aims to ensure that investee companies follow good governance practices.

The fund will consider a wide range of environmental and social characteristics on an ongoing basis. Environmental characteristics include carbon intensity, carbon emissions, energy efficiency, water and waste management, biodiversity, while social characteristics include product safety, supply chain, health and safety and human rights. Environmental and social characteristics are analysed by Fidelity’s fundamental analysts and rated through Fidelity Sustainability Ratings.