European corporate debt loses appeal amid political uncertainty

Boston - The resignation of Italian Prime Minister Matteo Renzi after his referendum defeat is just the latest reminder of the major political challenges to the integrity of the Eurozone.

The political uncertainty has caused us to take a hard look at riskier European assets, and high-yield corporate bonds. In some cases, credit spreads have not widened enough to create a compelling value case to compensate for this added risk - at least not yet. This makes us cautious on a relative basis.

So far, the market has had a muted reaction to recent important political events such as Brexit, Donald Trump's election and the Italian referendum. However, we believe these events are, in fact, very important. The market's lack of acknowledgement is more an indication of the short-term distortion that incredibly loose monitory policy can have on markets. The ECB meeting later this week on Thursday could impact the market's short-term direction, but we are focused on the long-term outlook.

Our view on European high-yield debt has grown increasingly bearish since the beginning of November. Compared to 2014, when European high-yield bonds looked particularly cheap, we now see no valuation advantage to European high-yield relative to the U.S. However, one notable exception is the U.K., where attractive high-yield valuations underpin our more upbeat view.

Developments that have influenced our view of European high-yield credit include both the pro-growth focus in the U.S. following the presidential election, and the rising risk of a Eurozone break-up.

Now, Italy has voted "No" in the referendum on constitutional reform. This was a referendum on which Renzi - now considered part of the establishment - had staked his future. Rejection of proposed reform could now lead to a general election and hand victory to the anti-establishment Five Star Movement.

The ballot outcome in the Eurozone's third-largest economy is seen as a barometer of whether anti-establishment, anti-EU sentiment is still ascendant in Europe. As risk-aware investors, we are not betting on a continuation of the status quo. As ECB Mario Draghi has highlighted, for the Eurozone to prosper, its members must be better off inside it than outside.

However, Italy's economy is beset by high unemployment, a fragile banking sector and high levels of government debt. According to the IMF, economic growth in Italy will not return to the levels seen before the 2008 financial crisis until the mid-2020s. This weekend's referendum result only makes the outlook more uncertain.

Bottom line: Heightened political and economic uncertainty after the referendum in Italy, and upcoming general elections in Germany and France in 2017, have detracted from the relative appeal of owing higher yielding European corporate debt.