European growth is slowing: so what? The regional macroeconomic environment is still supportive for investments in euro fixed-income strategies – particularly those that can dynamically manage the mix between safe government bonds and return-seeking credits.

European Fixed Income Is in the Sweet Spot

Challenging economic conditions may be surprisingly good for European bonds. We expect 2019 GDP growth in Europe to slow to 1.1%, with inflation at 1.4%. This mix of low growth and low inflation represents the “sweet spot” for investments in euro fixed-income markets. It indicates that the euro-area economy is neither too cold nor too hot, which helps reduce the main risks for fixed-income investors: recessions typically trigger an increase in defaults, while overheating can lead to a rapid increase in inflation and rising rates.

Monetary Policy…What Tightening?

Although the ECB stopped buying bonds for its asset purchase programme last December, monetary policy in Europe remains very accommodative. In fact, in March, the European Central Bank (ECB) altered its forward guidance to push a rate hike back into 2020 and announced a new round of financing for credit institutions (targeted longer-term refinancing operations or TLTROs) to start in September.

The announcement is positive for risky assets, and particularly for the financials sector. It supports the euro-area economy, reduces the probability of an imminent recession and augments a fiscal policy that is likely to turn expansionary this year.

Low Yields Don’t Necessarily Mean Low Returns

Yields remain ultra-low in Europe; however, this does not necessarily mean ultra-low returns for bond investors. Although the starting yield is a good predictor of future returns, it is not the only driver. That’s because price appreciation and roll-down are also important contributors for total returns. For example, look at the last 10 years’ returns from the Japanese government bond market (which has been stuck with low yields for decades). Even though the starting yield in each of these 10 years was near or below 1%, the total return was mostly significantly higher (Display).

How Best to Navigate Today’s Markets?

In the current environment, we think investors in euro-area government bonds can expect stable but relatively low returns, while holders of euro high-yield corporate debt should earn higher returns but with much more volatility. In our view, investing in a dynamically managed portfolio that can allocate to both these markets represents the best of both worlds. That type of portfolio – managed dynamically and with a benchmark-agnostic approach – can provide a more attractive yield on a risk-adjusted basis than the market. Our research suggests it can offer a significantly higher yield than the traditional euro aggregate benchmark (i.e. a blend of high quality government and corporate bonds), with lower duration and similar volatility,* despite having a higher allocation to high yield. Compared with higher-yielding euro-area government bonds (e.g. Italian BTPs), a dynamic portfolio can offer better yield and lower concentration risk. And although its yield is lower relative to the euro-area high-yield market, the quality of the dynamic portfolio is much higher. This is an important differentiator in this part of the cycle when lower-rated and highly levered bonds are much riskier.

Why Not Opt for Higher Yields in the US?

The US market, with its higher yields, may appear more attractive, but the cost of hedging US dollars back into euros remains elevated at 3%, making the adjusted returns for euro investors less appealing. And with the US at a more advanced stage in the credit cycle, risks are mounting for higher-yielding US bonds.

The Bigger Picture

Of course, political risks are elevated across the euro area, but we believe the ECB has the determination and the tools to ward off major crises. Over the longer term, we appreciate that structural issues in Europe remain, and that the effectiveness of monetary policy will likely decrease over time. Over the short/medium term we are mindful of heightened headline risk and volatility (e.g. ahead of European elections). Against this background, we believe a dynamic and benchmark-agnostic approach has more attractions than ever—in particular, because it has the flexibility to take advantage of increased volatility.

*over the last 5 years to 31 December 2018 both the representative portfolio and the Bloomberg Barclays Aggregate Euro Bond Index have exhibited average volatility between three to four percent.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams and are subject to revision over time. AllianceBernstein Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom.

Sources: AB, Bloomberg, Bloomberg Barclays Indices