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European Credit Outlook 2019 Summary

Core Content

This document provides a comprehensive credit outlook for 2019, analyzing the European credit cycle, supply and demand dynamics, political risks, and sector-specific performance. It outlines key themes and forecasts for both Investment Grade (IG) and High Yield (HY) credit markets, highlighting the potential for positive returns in IG and caution regarding HY due to tighter credit conditions.

Five Key Themes for 2019

1. The Credit Cycle has longer to run

   • European Credit Cycle is younger than the US one.
   • European IG is attractive; forecasted to deliver positive returns.

2. Credit conditions are getting gradually tighter

   • Reduced credit availability may lead to higher default rates.
   • HY is not yet attractive; forecasted to have moderately negative returns.

3. Political risks are high in Europe but so are risk premiums

   • Brexit and Italy are unresolved, but valuations are attractive.
   • Italian Credit is viewed as attractive, while UK Credit reflects Brexit risks.

4. Growth uncertainty is high but so are the risk premiums

   • A meaningful slowdown is priced in, but a rebound is possible with political clarity.
   • Hybrids (Non-Cyclical) are seen as defensive compared to Cyclical Non-Financials.

5. Net supply to increase driven by Financials

   • Senior Banks are expected to see increased net supply.
   • Non-Financial Corporates will see reduced net supply.

Credit Cycle Position

• European Credit Cycle is early

  • The cycle is not yet extended, and has room to run if political and global conditions remain stable.
  • Credit conditions are still very benign, and the economy is slowing to trend.
  • IG credit is expected to perform in line with equities and outperform government bonds.

• US Credit Cycle is late

  • The US is in a late-cycle expansion, with high leverage and credit conditions.
  • Credit underperforms equities, government bonds, and commodities in this phase.

Forecast and Valuation

• 2019 IG Spread Forecast: -15bp (vs. +69bp in 2018)
• 2019 HY Spread Forecast: +100bp (vs. +215bp in 2018)
• IG Excess Returns: 2.3%
• HY Excess Returns: -0.2%
• HY Default Rate: 2.5% (up from 1.9% in 2018)

Sector Recommendations

Investment Grade

• Favor: Energy, Hybrids, Utilities, Corporate Hybrids
• Avoid: Autos, Real Estate, Retail and Consumer, TMT

High Yield

• Favor: Energy, Food & Beverage, Chemicals, Packaging, Construction, Retail
• Avoid: None specified, but note caution for HY overall

Supply and Demand Dynamics

• Supply:

  • Gross supply is expected to increase, driven by Financials, Utilities, and Real Estate.
  • Net supply for Non-Financials is forecasted to decline by ~10%.
  • Senior Banks are expected to see increased net issuance, while Non-Financials will see a decrease.

• Demand:

  • ECB crowding is diminishing, and global flows are showing early signs of recovery.
  • European Credit funds experienced negative flows in 2018, but the trend is easing.
  • Insurance demand is limited by structural trends, but may improve later in the year.

Event Calendar for 2019

• EU parliamentary elections
• UK leaves the EU (Brexit)
• New ECB president takes office
• G20 summit
• European Parliament elections

Key Risks and Outlook

• Political risks remain high, especially with Brexit and Italy.
• Credit conditions are expected to tighten, increasing default risk.
• Leverage is high but not rising, indicating a stable but not aggressive cycle.
• US rates are rising, but not yet at levels that would cause significant damage.
• Global flows to European credit are expected to turn positive as investors repatriate funds.

Summary of Key Figures

Conclusion

The European credit market is expected to remain in an early cycle phase with positive returns for IG and a cautious outlook for HY. Political risks are high, but valuations are attractive. The market is expected to benefit from global flows and ECB policies, with a focus on defensive sectors such as Energy and Hybrids. The US is in a late cycle expansion, with credit underperforming compared to other asset classes. The credit cycle in Europe is projected to run longer if political and global conditions remain stable.