2 new views for the second quarter

We are downgrading European sovereign bonds and credit to underweight as the second quarter begins. Richard explains, with the help of this week’s chart.

We are downgrading European sovereign bonds and credit to underweight as the second quarter begins. Richard explains, with the help of this week’s chart.

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European bonds do not reflect the region’s better growth, we believe. Central bank purchases, investor yield-seeking and safe-haven flows have driven down yields on government and investment grade corporate bonds. Eurozone credit spreads have compressed well below those of U.S. peers. The result: Eurozone bonds seem pricey. See the chart above.

A disconcerting disconnect

The eurozone’s stealth recovery has steadily accelerated since mid-2016, with the region’s composite PMI hitting a six-year high in March. Eurozone inflation expectations have perked up from depressed levels, and we see global reflation reinforcing Europe’s comeback.

The disconnect between this economic outlook and heady eurozone bond valuations makes us nervous. We see near-term political risks waning after the key spring French election, even if Italy remains a concern. This may prompt an unwinding of safe-haven bund buying that drove two-year yields to nearly -1%. Rising growth and inflation expectations could stoke market jitters about the European Central Bank starting to wind down its accommodative measures, though we do not see near-term changes. A jump in sovereign yields could spark European credit market outflows, hurting richer investment grade bonds. Expensive valuations are evident in relatively tight credit spreads across eurozone countries despite the differentiation priced into sovereign bonds.

Bottom line

We see downside risks for European bonds. We prefer selected subordinated financial debt within European credit and favor high-quality U.S. credit and emerging market debt over government bonds, but credit valuations are elevated across the board. We prefer to take risk in equities and see upside for European stocks on stronger economic growth. Read more market insights in my Weekly Commentary.

Richard Turnill is BlackRock’s global chief investment strategist. He is a regular contributor to The Blog.

Investing involves risks, including possible loss of principal. International investing involves special risks including, but not limited to currency fluctuations, illiquidity and volatility. Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of April 2017 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

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