In Europe, the late start to the policy cycle gives the ECB some time to assess incoming inflation and growth data. The considerable amount of monetary tightening priced in by the market should provide a degree of protection to fixed income. Euro investment grade strategies offer higher yield and are typically shorter in duration than government indices and therefore should remain a core portfolio building block.
In early 2023, the roadmap for investing in fixed income markets seemed pretty clear. Falling inflation and gradually slowing growth indicated that the top to the Fed’s rate cycle was within view, and that was positive for most assets. Recent data has challenged that view. Activity has improved and the downward trajectory of inflation now looks likely to be a gradual glide rather than a dramatic decline.
Even in Europe, the significant disinflationary impulse from falling energy prices was expected to cause CPI to fall quite quickly. Things have not gone according to plan, however, with core CPI holding up. There could be seasonal factors behind some of this unexpected strength but it has forced central banks to sharpen their hawkish rhetoric. This more hawkish posturing has put markets on edge, with investors now keenly observing the data before deciding where to invest next.
The big fear is that the Fed’s Target Rate may have to rise significantly and with higher rates come the greater risks that the economy tips into a recession. While the ECB may be pushing a similarly hawkish line, the fact that it was so late to start raising rates means it is nowhere close to delivering the final rate rise. The Target Rate is at just 2.5% and the market prices a further 170 bps of tightening, with a 50 bp rise nailed on for the March meeting. While this approach is justified by inflation, the growth backdrop is not nearly as robust as it is in the US – euro area Q4 2022 GDP was flat.
The degree of tightening priced coupled with the soft growth environment should limit the risks that the ECB goes beyond what is currently priced. Indeed, recent comments from ECB member Ignazio Visco suggest dissent within the council as to how high rates may need to go. This could prove supportive for euro fixed income exposures. EMEA-domiciled euro investment grade ETFs have seen inflows of $3.7 billion year to date1, continuing to gather assets in February despite the weakness of returns.
Euro investment grade credit remains an interesting exposure for several reasons:
In short, the higher yield and lower duration should provide some defensive posture for a portfolio. The obvious caveat is that wider spreads could lead to underperformance. However, if the US is any guide, around half of the negative returns in investment grade credit for February were driven by higher rate expectations rather than wider spreads.
Spreads may also come under pressure as a result of reduced purchases by the ECB. There are run-offs of EUR 2.56 billion per month over the coming 12 months from the CSPP portfolio, of which only a portion will be reinvested4. There is a twist. As the ECB notes, “the Governing Council decided on a stronger tilting of its corporate bond purchases towards issuers with a better climate performance during the period of partial reinvestment.” These purchases run until June 2023 and could provide relative support for ESG-aligned strategies.
Soaring energy prices and a focus on defensive companies meant 2022 was not perceived as a good year for ESG. That said, not all strategies underperformed. Figure 1 shows annualised returns against volatility, plotted over 1, 3 and 5 years to 28 February 2023 for the Bloomberg SASB Euro Corporate ESG ex Controversies Select Index against the Bloomberg Euro Agg: Corporate index. The Bloomberg SASB Index had higher returns than the market-weighted parent index during all three periods. Volatility has been higher over the past 12 months for the Bloomberg SASB ESG index but over the longer time periods has been lower.
Figure 1: Annualised Returns vs. Volatility
For these indices, the approach to index construction aims to maximise the ESG score while at the same time requiring the alignment of sector and other risk characteristics with the parent index. This design aims to reduce risks of material divergence with the market-weighted index. For this reason, these strategies can be used as core building blocks for benchmark-aware ESG investors.
An attribution of the Bloomberg SASB ESG Index versus the Bloomberg Euro Agg: Corporate index for 2022 demonstrates the value of the dual optimisation objectives. Asset allocation, largely the difference in sector allocations, was still a drag on the performance of the Bloomberg SASB ESG Index but by just more than 9 bps. However, this was more than offset by security selection, which resulted in 42 bps of outperformance5.
1 Source: Bloomberg Finance L.P., as of 3 March 2023
2 Source: Bloomberg Finance L.P., as of 9 March 2023
3 For instance, the Bloomberg Euro Agg: Corporate index has a duration of 4.5 years against 7.2 for the Euro Treasury index.
4 The ECB wants to keep total run-off from all maturing securities to EUR 15 billion per month. Source: European Central Bank, as of 9 March 2023.
5 Source: Bloomberg Finance L.P., as of 31 December 2022.
Marketing Communication. General Access. For professional investor use only.
Standard & Poor’s, S&P and SPDR are registered trademarks of Standard & Poor’s Financial Services LLC (S&P); Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC (Dow Jones); and these trademarks have been licensed for use by S&P Dow Jones Indices LLC (SPDJI) and sublicensed for certain purposes by State Street Corporation. State Street Corporation’s financial products are not sponsored, endorsed, sold or promoted by SPDJI, Dow Jones, S&P, their respective affiliates and third party licensors and none of such parties make any representation regarding the advisability of investing in such product(s) nor do they have any liability in relation thereto, including for any errors, omissions, or interruptions of any index.
Investing involves risk including the risk of loss of principal.
The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA’s express written consent.
The information provided does not constitute investment advice as such term is defined under the Markets in Financial Instruments Directive (2014/65/EU) or applicable Swiss regulation and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell any investment. It does not take into account any investor's or potential investor’s particular investment objectives, strategies, tax status, risk appetite or investment horizon. If you require investment advice you should consult your tax and financial or other professional advisor.
All information is from SSGA unless otherwise noted and has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.
ETFs trade like stocks, are subject to investment risk and will fluctuate in market value. The investment return and principal value of an investment will fluctuate in value, so that when shares are sold or redeemed, they may be worth more or less than when they were purchased. Although shares may be bought or sold on an exchange through any brokerage account, shares are not individually redeemable from the fund. Investors may acquire shares and tender them for redemption through the fund in large aggregations known as “creation units.” Please see the fund’s prospectus for more details.
Past Performance is not a guarantee of future results.
This communication is directed at professional clients (this includes eligible counterparties as defined by the appropriate EU regulator or Swiss Regulator) who are deemed both knowledgeable and experienced in matters relating to investments.
The products and services to which this communication relates are only available to such persons and persons of any other description (including retail clients) should not rely on this communication.
Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates raise, bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
Investing in high yield fixed income securities, otherwise known as "junk bonds", is considered speculative and involves greater risk of loss of principal and interest than investing in investment grade fixed income securities. These Lower-quality debt securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer.
There are risks associated with investing in Real Assets and the Real Assets sector, including real estate, precious metals and natural resources. Investments can be significantly affected by events relating to these industries.
International Government bonds and corporate bonds generally have more moderate short-term price fluctuations than stocks, but provide lower potential long-term returns.
Flows are as of the date indicated, are subject to change, and should not be relied upon as current thereafter.
Investing in commodities entail significant risk and is not appropriate for all investors. Commodities investing entail significant risk as commodity prices can be extremely volatile due to wide range of factors. A few such factors include overall market movements, real or perceived inflationary trends, commodity index volatility, international, economic and political changes, change in interest and currency exchange rates.
Investing in foreign domiciled securities may involve risk of capital loss from unfavourable fluctuation in currency values, withholding taxes, from differences in generally accepted accounting principles or from economic or political instability in other nations. Investments in emerging or developing markets may be more volatile and less liquid than investing in developed markets and may involve exposure to economic structures that are generally less diverse and mature and to political systems which have less stability than those of more developed countries.
The information contained in this communication is not a research recommendation or ‘investment research’ and is classified as a ‘Marketing Communication’ in accordance with the Markets in Financial Instruments Directive (2014/65/EU). This means that this marketing communication (a) has not been prepared in accordance with legal requirements designed to promote the independence of investment research (b) is not subject to any prohibition on dealing ahead of the dissemination of investment research.
© 2023 State Street Corporation.
All Rights Reserved.