KBRA Financial Intelligence

3 Things in Credit: Complacency, Trade Progress, and European Appeal

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Welcome, market participants, to another 3 Things in Credit. I’m Van Hesser, Chief Strategist at KBRA. Each week we bring you 3 Things impacting credit markets that we think you should know about.

This week I came across a fascinating interview Reuters conducted with Nicolai Tangen, CEO of Norges Bank Investment Management, the world’s largest sovereign wealth fund. When asked what the biggest risk to financial markets was today, he responded, “decoupling,” the fragmenting of the world economy. “You are in a situation now,” he said, “where you have a hot war, you have a cold war, you’ve got a trade war, you’ve got a tech war, and it leads to lower economic growth, higher inflationary pressure, and more uncertainty.” In the fund’s stress-test scenario for a “fragmented world,” Mr. Tangen said his fund could lose up to a third of its value.

Wow.

This week, our 3 Things are:

1. Complacency. It’s back.

2. Trade progress. What’s the evidence?

3. European appeal. It’s become a fashionable trade. My European counterpart weighs in.

Alright, let’s dig a bit deeper.

Complacency.

This week, a story we saw everywhere all the time was that the S&P 500 is right back to where it was April 2, the day the new administration announced its retaliatory tariffs. It’s essentially the same story with regard to investment-grade and high-yield credit spreads.

Now, you could argue that there was plenty of “pre-announcements” of tariffs that drove selloffs in risk assets ahead of that “official” day, so we’re still at levels weaker than where we were on election night. But a commonly held view is that we’ve repriced a bit, maybe we’ve removed some of the froth from risk valuations, and now we’re settling into a more defensible trading range.

Not so fast.

Before we breathe a sigh of relief, there are at least two formidable issues investors will encounter in the near future: (1) the actual effects of the trade war, and (2) market reaction to the debt and deficits, which are about to take center stage as the administration’s tax cut plans are rolled out.

On point 1, the effects of the trade war, it takes time for those effects to materialize. Realistically, this will take place over the next three to six months, although press reports coming out of the meeting last week between the White House and the CEOs of Walmart, Target, and Home Depot warned of empty shelves within weeks. And soft data such as this week’s decidedly weak Dallas Fed Manufacturing survey reflects businesses’ mounting concern about deteriorating business conditions.

On point 2, the White House has set July 4 as the goal for passage of a multitrillion tax cut package, the GOP’s top legislative priority. The plan calls for making permanent the Tax Cuts and Jobs Act (TCJA), as well as additional cuts campaigned on including no tax on tips, no tax on Social Security, no tax on overtime, making auto loans deductible, and allowances for writing off the cost of building factories in the U.S.

The fiscal initiatives come at a time when sovereign debt to GDP has hit an all-time high in the U.S., despite the longest peacetime expansion in history of nearly 16 years, excluding the two months of COVID-related recession. Enacting the TCJA alone will increase the debt burden substantially, a situation made worse by the fact that interest rates are structurally and materially higher than they were when debt was deployed massively to deal with the aftermaths of the GFC and COVID. In our future is a debt ceiling battle, and debate over the “pay-fors,” which inevitably will involve the third rail of American politics, entitlements.

Volatility may have died down for the time being. We remind investors that it is unlikely to stay that way.

Alright, on to our second Thing—Trade progress.

We would be the last to say the trade war “plan” is settling into a predictable place. We know enough to know this is all still, what’s the word, fluid. But there are elements in this story that are better defined. First, we believe trade deals, or at least talk of trade deals, are becoming the dominant narrative coming out of the White House, a change from the rollout shock that consisted of sweeping universal tariffs, augmented by the threat of additional reciprocal levies. Of course, we would be well advised to curb our enthusiasm with regard to what constitutes a “deal” as opposed to what might just be progress toward a “letter of intent” or even more simply, a dialogue. Trade deals typically take years to finalize.

But the uncertainty has diminished a bit when we learn, for example, that the EU’s trade commissioner says that the US and EU have made progress through multiple rounds of negotiations. And investors should take comfort in the EU’s comment that “they”—the U.S.—understand us a little bit better, and we have a little bit more understanding.” That tells us that compromise is still possible.

And then there are other motivations that bring parties together. In the U.S., poor polling results could provide an impetus to act, to address the cause for concern. In China, deteriorating economic data, such as its manufacturing output for April, could be the catalyst. And sure enough, there are now reports that the U.S. and China are actually engaged in negotiations.

Looking ahead, hard data in the U.S. matching the soft data would continue to incentivize the U.S. administration to look for ways to change the narrative (and the economic trajectory). And with the threat of those aforementioned empty shelves and snarled supply chains looming, it is in the administration’s interest to seek out trade “wins.” That will surely help polling and economic outcomes, not to mention credit risk premia.

Alright, on to our third Thing—European appeal.

Investors have taken a shine to the opportunity in European and UK credit here in Q1, no doubt in response to the changing world economic order. Here to walk us through this story is my colleague Gordon Kerr, KBRA’s European Macro Strategist. Gordon, welcome to the podcast.

Gordon: Thanks, Van. Happy to join.

Van: Gordon, you and I have launched a new quarterly series, The Forward Look, in both U.S. and UK/Europe versions, with a goal of steering our readers (and listeners) to what forces we think are the most important ones shaping credit markets over the near term.

So, let’s dig into your inaugural Forward Look.

From an investor flow standpoint, Europe has been the beneficiary of the “sell America” trade here in Q1, but you point out that the U.S. tariff regime really is a double-edged sword for the UK and the continent. Walk us through the two sides of that story.

Gordon: You are right, there are two sides to this. First, there’s the obvious—tariffs tend to dampen activity and weigh on growth. And Europe wasn’t exactly starting from a strong place, with GDP expectations for the year sitting at around 1%.

From a European perspective, tariffs would hit key sectors like autos and pharmaceuticals, impacting major economies such as Germany, France, and the UK. These countries are still likely to be the most exposed, though the U.S. administration appears to be softening its stance on the automotive sector, though that is likely to be more focused on helping U.S. manufacturers.

On the flip side, U.S. policy actions, not necessarily just the tariffs, have prompted a notable reaction in Europe. One example—something almost unthinkable at the start of the year—Germany has opened up its fiscal taps. There’s been a broader uptick in European defense spending, and the European Commission has launched several growth-oriented initiatives. I wouldn’t quite call it deregulation—that’s not very European—but we are seeing a push for simpler, clearer rules.

Globally, the response to U.S. policies has led to diversification out of the U.S. That means that many countries are looking for trading opportunities within Europe. Plus, from a capital perspective, there has been a drive of fresh flows into what had arguably been an undervalued Europe.

Why call it undervalued? Because, as you’ve also pointed out in the U.S. context, Europe enters this phase from a position of relative strength. Growth may have broadly been muted, but banks are well capitalized, corporate balance sheets are solid, and both energy prices and interest rates have been trending lower. Disinflation has brought Europe closer to target. And importantly, Europe’s trade exposure to the U.S. is under 20%—meaning the impact from tariffs should be more limited than in other regions. For the UK, it is slightly more than 20%.

Van: What do you see as the most important factors for credit investors to watch in Q2?

Gordon: One key area will be sectors most exposed to tariffs. We’ll be monitoring for signs of earnings pressure and any uptick in defaults or insolvencies. That said, we don’t expect a significant spike. Many firms have already weathered the pandemic, elevated energy costs, and tighter financing conditions.

Still, not all companies are equally resilient. Smaller and midsize firms—particularly those with tight margins and high leverage—could be more vulnerable to shocks. These are the names to watch closely.

We're also keeping a close eye on the labor market. Surveys show European consumers are increasingly worried about job security, and the savings rate remains elevated as a result. While we do expect some softening in employment, we believe it will be a gradual decline rather than a sharp downturn.

Van: Pull all of this together for us in terms of the opportunity in European credit. Spreads are relatively tight compared to long-term averages. Do you expect them to hold in or are you looking for risk premia to build?

Gordon: I hesitate to overquote BlackRock CEO Larry Fink, but he’s been one of the most vocal proponents of the pro-Europe trade recently—from his remarks at Davos to his firm’s Q1 earnings call. And I tend to agree with his view. European equities have outperformed, and credit markets continue to look compelling. They are not undervalued in comparison to their long-term averages with both high-yield and investment-grade both pricing inside of their 10-year averages, but we think they still look interesting given the “sell America” movement you highlighted upfront.

Looking ahead, the Q2 2025 European credit environment is defined by a mix of resilience and emerging pressure points. Stable labor markets, solid earnings, and still attractive fixed income yields provide a strong foundation for investors.

At the same time, external risks—especially those tied to U.S. policy—and lingering fiscal strains in parts of Europe call for an overall prudent stance. In my view, this is a moment to be cautious but ready to act. The tariff story isn’t over yet, and positioning carefully around that uncertainty will be key.

Van: That’s great color, Gordon. This story is just beginning to unfold, we’ll be watching closely.

So, there you have it, 3 Things in Credit:

1. Complacency. Before you get comfortable that the pricing of credit risk now fully reflects the risk, we’d remind you that we’re not out of the woods yet.

2. Trade progress. You’ve got to start somewhere, and we’re starting to see some signs of progress.

3. European appeal. Tariffs are a double-edged sword—another headwind to growth, but, selectively, a worthy diversification play away from the U.S.

As always, thanks for joining. We’ll see you next week.