Why Europe is on a firmer footing

It doesn’t leave a lot of room for European bonds to weaken and we feel 10-year German bund yields are capped at 1 per cent for the time being. In other words, we expect a narrow range of 0.60 per cent to 1 per cent on bunds.

We believe the periphery will continue to do well over the next few months. Now that the Greek crisis is over, we can concentrate on the fundamentals which show a number of green lights flashing. Purchasing managers’ indices are improving in countries like Italy and Spain, while growth is being revised higher and unemployment is coming down meaningfully in Portugal and Ireland.

Periphery

So while the bonds of these countries have done well recently, there is more value to come in periphery bonds, such as those from Italy. We also like Slovenian bonds as the country continues to improve and we have recently added to Cyprus, which came to market in May with a new seven-year issue.

It may seem inconceivable at present but there will be a time when inflation-linked bonds in Europe will become an attractive investment again. The knock-on effect from a weak euro is still not fully appreciated and with a number of countries loosening the strings on their austerity programmes, inflation may well surprise on the upside. It is definitely something on the radar.

It is likely the euro has been used lately as a funding currency against emerging market currencies, and a further rise in risk aversion leading to more emerging market currency correction may well have the perverse effect of strengthening the euro from its current level.

Corporate bonds

Another part of the market where value continues to be uncovered is in lower-rated corporate bonds. We have invested in European high yield for some time and we continue to see good value in such parts of the market as single B-rated companies. Faced with a limited amount of new issuance since the beginning of May, it is worth turning to the secondary market to find liquidity; companies where prices have come down but where our conviction in the names remains high.

It is fair to say that over the longer term, more volatility is anticipated. While the rhetoric from ECB president Mario Draghi and his success at ‘verbal easing’ will keep rates low for a sustained period, Europe will have to face its own taper tantrum at some stage once its quantitative easing ends. But for the time being all eyes are on the US Federal Reserve.

Stephane Fertat is portfolio specialist for fixed income at T Rowe Price

EXPERT VIEW

Gibson Smith, chief investment officer, fixed income and portfolio manager at Janus Capital, assesses the outlook for monetary policy across developed markets:

“While the Bank of England (BoE) is presumed to be second in line behind the US Federal Reserve in raising interest rates, much of the developed world remains firmly in the accommodative camp. More than half of the world’s economy falls under the auspices of loose or accommodative monetary policies. Similar to the situation in the US, largely absent inflationary pressure in the UK may delay the BoE’s initial hike. Still, sterling should have winds at its back as the timing of the BoE move becomes clearer. Within the eurozone, the Fed’s delay in raising rates was met with comments from the European Central Bank (ECB) that it may extend its quantitative easing programme. Over six months into the ECB’s programme, core inflation has moved off its lows, although headline data remains vulnerable due to weak energy prices.”