We are downgrading European sovereign bonds and credit to underweight as the second quarter begins...[as they] do not reflect the region’s better growth. Eurozone credit spreads have compressed well below those of U.S. peers. The result: Eurozone bonds seem pricey.

Written by Richard Turnill (BlackRockBlog.com)

Central bank purchases, investor yield-seeking and safe-haven flows have driven down yields on government and investment grade corporate bonds

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.