Recent inflation data took markets by surprise and were a further sign that the disinflation trend continued in the US and in Europe. However, it seems that disinflation has been exaggerated by a few volatile categories that may not persist. It remains a fact that this broad deceleration is an encouraging sign that overall price pressures are gradually receding. Read more on the outlook for European Asset Backed Securities.
European ABS has demonstrated resilience in the volatile market environment and again showed positive performance in November with spreads tightening coupled with the high carry. Credit curves flattened again and non-senior bonds outperformed. Despite the tightening of spreads and lower swap rates, valuations are attractive, both from a relative and absolute perspective. Spreads in broader fixed income markets tightened more, increasing the relative value of European ABS.
With the European economy slowing and inflation declining it seems that we are out of the woods. However, there is still quite some uncertainty on the way forward of central banks. In addition, the geopolitical issues are not likely to fade anytime soon, which could result in volatility in the short term. As 2023 has shown us, markets can be wrong and might be surprised by central banks' communications and/or incoming data.
From a fundamental perspective, with lower credit availability and even much lower affordability, the ability of corporates and consumers to refinance or get access to credit are difficult. Volumes across credit markets are much smaller currently. Housing markets meanwhile are showing a mixed picture: while in some countries house prices increase again, others have seen consecutive months of declines.
Overall, we expect defaults to increase and arrears to go up, especially for products that are at or close to their reset or maturity dates. Still, most borrowers seem to be able to refinance as demonstrated by significantly higher prepayment rates (CPRs) around reset dates. For the ones that have difficulties, losses are very limited given that asset prices have increased and household balance sheets are still healthy.
Even in case of a loss on the loan, ABS structures can withstand substantial stress scenarios. Payment disruption will be zero to close to minimal owing to structural elements like (liquidity) reserve funds, excess spread, cashflow diversion triggers and subordination, which have almost all increased in newly issued ABS. We have no immediate concerns regarding ABS fundamentals, but we are getting increasingly selective.
Despite the fact that spreads tightened, European ABS still stand out from a valuation perspective and stand out in fixed income markets in offering both absolute and relative value. Low interest rate duration provides stable returns in the current uncertain interest rate environment. The high carry is appealing and dampens volatility, as we have seen in the last few months, and non-senior tranches provides compelling opportunities to earn additional income. Meanwhile, with Euribor close to 4%, current yield is quite substantial.
With the uncertain outlook for the European economy and the way central banks will act, there will likely be periods of weakness in the markets going forward as uncertainty about inflation, the growth prospect of the eurozone economy and the impact of higher interest rates remains. However, weakening of the fundamental picture has already been priced in and investors in ABS seem to get compensated for taking credit risk. High-carry products are therefore set to outperform especially if incoming macroeconomic data was to point to easing inflation or an increased probability of a recession. The technical picture is not much of a driver going into year end and is looking neutral to slightly negative. This may, however, result in a more positive technical if demand remains strong and issuance dries up. Overall, we do not expect spreads to tighten as much as they did recently, and they will not be the largest contributor to returns.
Altogether, income (coupon) tends to drive longer-term total returns more than spread movements over time and is an important component of (expected) total returns. The current macro backdrop has also set the stage for the European ABS market to deliver attractive total returns from this point forward. We believe that ABS is set to outperform in an environment where there are many uncertainties. The relatively high carry for ABS coupled with valuations being attractive from a relative and an historical perspective remains in place.
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