In this article
- Reasons for optimism about the outlook for services inflation
- Protection against a possible materialisation of risks?
- A suitable entry point for cautious investors
- About the BNP Paribas Euro Government Bond fund
In our view, the latest economic indicators fully support the scenario of a soft landing for the eurozone economy, with weak growth and inflation slowing. This environment is favourable for fixed income.
In this context, many investors are wondering when they should increase interest rate risk. Alberto Talero, manager of the BNP Paribas Euro Government Bond has a clear view on this: he believes that now is the time to do so.
My argument for increasing interest rate risk is based on fundamental and technical reasons. From a fundamental point of view, I expect inflation to continue to fall gradually until it reaches the European Central Bank’s (ECB) target of 2% by the end of 2024. Looking at technical reasons, pricing seems asymmetric when looking at the number of ECB cuts discounted by the market.
Services inflation, reasons for optimism
If we focus on the trend of services inflation, which is most closely linked to wage growth, we see that there are reasons to be optimistic.
Negotiated wage growth data for the eurozone in the final quarter of 2023 showed a slowing in the pace of growth to 4.5% from 4.7% in the third quarter. More importantly this increase in wages is not being translated into greater consumption, which would fuel inflationary pressure. Moreover, the fall in inflation implies, by definition, a rise in monetary real interest rates, which equates to increasingly restrictive monetary policy, in a context in which the rate of growth is already quite weak.
Finally, when we look at business profit margins, they remain at levels above the average of the years prior to the pandemic, albeit with a downward trend. This suggests that companies are increasingly absorbing pressure for higher wages rather than continuing to pass on higher costs to the consumer and thus contributing less to inflationary pressures. Given this scenario, we believe that the ECB will gradually lower interest rates until it reaches a neutral interest rate of around 2%.
Protection against a possible materialisation of risks?
From a technical and valuation point of view, the market continues to price in a “Goldilocks” scenario in which inflation progressively falls while the pace of growth increases. Such a scenario would tend to lead investors to buy risky assets such as stocks or credit.
From a market valuation point of view, we are reaching levels that are tight in terms of credit spreads relative to government bonds. That is why the risk is asymmetric. In the event of a materialisation of risks it would imply a drop in growth. At current levels, yields of government bonds would give us the necessary protection to cope with a sudden fall in growth.
Finally, in the first months of the year the market has gone from one extreme, in discounting between 6 and 7 rate cuts by the ECB in 2024, to another, discounting only between 3 and 4 cuts today.
Conclusion for cautious investors
We believe that the market is now close to a new extreme where it anticipates that inflation will not fall quickly and therefore the ECB will lower policy rates slowly.
Given current levels and our inflation outlook for this year and next, we believe that gradually starting to increase interest rate risk is the appropriate strategy. This enables investors to lock in the current level of interest rates (both nominal and real), which we consider to be attractive from a valuation point of view.
Investing in bonds today not only allows us to take advantage of a relatively high level of interest rates but also creates scope for capital gains if, as we expect, interest rates fall over the course of the year.
About the BNP Paribas Euro Government Bond
- Flagship fund of the fixed income team with more than 1,700 M Euros under management.
- Diversification into government debt, supranational issuers, agencies and regional authorities.
- A combination of top-down (interest rate risk, yield curve, credit spreads) and bottom-up (relative value trades, primary markets) strategies that help diversify alpha sources.
- It also diversifies through derivative strategies, whether inflation swaps or interest rate, options and futures swaps to facilitate the optimisation of the fund’s active management.
- Article 8 Fund according to the SFDR Regulation, with a minimum of 20% in sustainable investment.
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