Fixed income in Southern Europe: A good idea after the rate hike?

Inflation takes no prisoners. And neither do successive interest rate hikes. Public debt in the European Union as a whole has never ceased to be a headache at any time, but in recent years, with the outbreak of the covid-19 pandemic, it seemed to have ceased to be a priority. Now, in the current scenario, it's once again a matter of growing concern in the main European institutions, especially in the case of southern European countries.

Andrés Sánchez Balcázar and Ella Hoxha, co-managers of Pictet Absolute Return Fixed Income

The outlook for European sovereign debt appears weak compared to the US.  Inflation indicators are much higher and the effects of the second-round of price increases are appearing on wages.  The ECB risks falling behind in its battle against the inflation and being forced to catch up on monetary tightening if inflationary pressures do not subside.  In addition, the war in Ukraine and uncertainty over energy supplies add more risks.

In this state of affairs, the markets have turned to the US for guidance on the interest rate direction, estimating that by the end of the year the Federal Reserve will pause its tightening.  But it is not clear that inflation is going to fall enough, so it looks like the market is betting on the U.S. economy to weaken.  For now, the Federal Reserve, in order to reaffirm its credibility against inflation, needs to be aggressive, as the U.S. labour market remains tight.  The ECB, in this environment of less favourable monetary policy and concerns about economic growth, has no choice but to also be more aggressive, facilitated by the fact that, although inflation in the Euro Area remains high, yields of the debt of peripheral economies have not suffered financing problems so far.

The fact is that, given the high correlations between asset classes and a high degree of uncertainty, we maintain a defensive position.  We continue to cut exposure to yield-to-maturity spreads in Europe.  We have downgraded euro area sovereign bonds to underweight and further reduced sensitivity to interest rate changes, mainly in Europe, with short positions peripheral countries sovereign debt, having underweight Italian and French government bonds against German ones.