Europe's market under the tariff storm: Central bank interest rate cuts begin, which sectors are most vulnerable?

UBS expects the European Central Bank to cut rates by 25 basis points to 2.0% at its June meeting, which is in line with market expectations. UBS's baseline scenario predicts that global economic growth will gradually slow in the second half of 2025, but with a healthy balance sheet, low default rates, and technical support, spreads will remain range-bound (forecasting EU investment-grade/high-yield bond spreads at 100/325 basis points by December 2025), although news related to tariffs may cause market volatility. UBS believes that investment-grade financial bonds are an ideal choice, especially compared to corporate bonds. The energy and basic industrial sectors appear most susceptible to tariff news, with currently only selective micro opportunities, while capital goods and utilities sectors appear most defensive. UBS still prefers tactically over-weighting the iTraxx Main index relative to EU investment-grade bonds positions, as UBS expects tariff news in July may once again cause market volatility. The European private credit market stands out due to its strong fundamentals and ample dry powder (uninvested funds) to support liquidity and suppress hard defaults. UBS's top ten global macro themes for the second half of 2025 1. Economic data and tariff decisions shaping new scenarios Recent EU economic data (slightly lower than US) unexpectedly improved - UBS's proprietary economic risk indicator has decreased from its negative value three months ago - challenging UBS's initial recession scenario (Scenario 1). Although front-loading of exports may temporarily boost EU growth in the second quarter of 2025, UBS expects this momentum to fade later in the year, consistent with UBS's basic assumption of weak growth in the third and fourth quarters of 2025. With the US government considering imposing 50% tariffs on EU goods, UBS's downside scenario implies an effective tariff rate of around 30%, with EU GDP halving to 0.4% in 2025 and 0.5% in 2026. In this environment, UBS believes spreads may reach a peak of around 120/425 basis points in the third quarter and narrow by the end of the year, supported by monetary policy and strong fundamentals. However, a recent ruling by the US International Trade Court to prevent immediate implementation introduces legal complexity and delays, reducing the risk of rapid execution. This development suggests that the economic impact may not be as severe or direct as initially feared. In this context (without tariffs on Europe), spreads may test their low point year-to-date, around 90/285 basis points (compared to the current 100/320 basis points). 2. European Central Bank - balancing growth support and tariff risk UBS expects the European Central Bank to cut rates by 25 basis points to 2.0% at its June meeting, which is in line with market expectations. Updated macro forecasts should reflect: 1) slowing economic growth in 2026; 2) declining inflation rates for 2025-2026 considering recent developments such as US tariffs on Europe. However, a recent ruling by the US International Trade Court has introduced delays and legal obstacles, reducing immediate downside risks (see point 1), supporting UBS's view that the European Central Bank may maintain a more gradual easing mode. UBS expects another and final 25 basis point rate cut to 1.75% in July as the 90-day pause ends, trade tensions may escalate again, and economic growth data weakens. UBS believes that the European Central Bank will prioritize supporting growth in both its baseline and downside scenarios, but given the uncertainty of inflation outlook, particularly in the event of EU retaliating on tariffs, the council may remain divided. UBS believes that the dovish stance of the European Central Bank supports this asset class in both UBS's baseline and downside scenarios. 3. Spreads indicate limited macro and micro risks In May, purchasing managers' indices (PMIs) slowed slightly, but manufacturing activity continued to increase (49.2), boosting risk sentiment despite ongoing trade uncertainty. Bank lending and credit conditions further improved, with private sector credit growth recovering (from +0.1% to 2.7%) and loan rates falling (from -0.2% to 3.9%). Strong earnings from European businesses have boosted confidence in fundamentals, with signs of cracks or defaults in low-rated credit still limited, supporting spread resilience. After the volatility peak observed in March, investors continue to find value in arbitrage strategies, benefiting from low default rates (around 1.5%) and a strong fundamental environment these factors collectively explain the continued inflow of active and passive funds. UBS's market pressure implied model (most accurate in recent quarters) shows fair value at around 110/345 basis points, roughly in line with current valuations (100/325 basis points). 4. How will spreads react when trade news reemerges? After the US announced tariffs on "Liberation Day," spreads initially widened across the board but the reaction was relatively orderly with no clear signs of panic selling. Looking ahead, UBS expects increased volatility around tariff news throughout the summer, especially after the 90-day pause ends. In light of this, UBS reviewed industry performance during key tariff-related announcement periods - notably "Liberation Day" (EU investment-grade/high-yield bond spreads widened by +26/91 basis points) and the announcement at the end of last month of possible 50% tariffs on EU goods (EU investment-grade/high-yield bond spreads widened by +3/16 basis points). During these two periods, despite significant differences in index-level trends, a consistent pattern emerged: 1) Beta coefficients for investment-grade financial bonds during spread widening were significantly lower than in previous cycles/impacts, reflecting investors' belief that there is no widespread systemic risk; 2) Investment-grade energy and high-yield bonds were the most impacted by spread widening during these periods, reflecting higher sensitivity to tariff news. Overall, UBS remains cautiously optimistic about the market environment and the performance of investment-grade financial bonds relative to other sectors in the face of trade uncertainties.The basic industrial sector is the most sensitive industry to tariff news.3) Investment-grade capital goods and investment-grade/utilities sectors have performed well, maintaining their position as the most defensive sectors. 4) The volatility in the investment-grade/high-yield technology sector has increased, especially vulnerable to special risks/events. Overall, UBS expects new tariff announcements to lead to industry differentiation. 5. Can we still find value in the most tariff-sensitive industries? Amid increasing market volatility related to the reemergence of tariff news, opportunities in the most tariff-sensitive industries seem to be increasingly driven by individual stocks rather than macro factors, given that credit spreads have compressed to low levels. In the energy sector, weak global demand and incremental supply from the Organization of Petroleum Exporting Countries (OPEC +) and its allies add pressure to the outlook, with companies with strong balance sheets and low breakeven points faring the best. Companies with high leverage and reliance on asset sales seem more susceptible to volatility. In the chemicals industry, the focus is on the impact of tariffs on input costs and pricing power. Diversified companies with pricing flexibility appear relatively resilient, while those reliant on imported inputs or with limited pricing power face risks to profitability. In mining, macro headwinds from declining metal demand and trade-related uncertainties have affected market sentiment. Mining companies with strong balance sheets and diversified exposures perform better, while those with high costs or focused on a single commodity are more vulnerable. In equipment, companies with stable aftermarket revenues are more defensive than those reliant on new equipment sales. 6. Will expected capital flows impact EU credit positively? In credit, spreads widened in an orderly manner around "D-Day," reflecting most investors being well-prepared before the event occurred. Early capital flows (a key driver of the stock market) also affected credit, with US equities performing poorly during the tightening period in January/February and selling off in March. This backdrop allowed many EU investors to have a less urgent and higher cash cushion to address tariff announcements, tempering the initial spread widening, especially in high beta sectors. Looking ahead, UBS expects continued volatility as markets adjust to US tariffs over the next few months, with a potential significant rotation from the US to the EU in global equities. However, unlike equities (where UBS forecasts a flow of 1.2-2.0 trillion euros in the next five years), credit rotation is largely completed, with current valuations well supported. UBS believes that only significant growth differentials between the US and Europe will drive a new paradigm shift in credit valuations. 7. Financial sector: quietly outperforming.... In early May, supported by strong earnings from core European banks, the financial sector saw spreads tighten, despite somewhat weaker data on interest income and non-performing loans (NPL) levels. Liquidity remained good but somewhat passive, with increased geopolitical risks (such as US tariff threats) adding caution but not undermining market sentiment. Overall, credit quality remained stable. Looking ahead, UBS expects moderate investment-grade primary market issuance to support better secondary market performance, especially in additional Tier 1 capital bonds (AT1) and Tier 2 capital bonds (T2). UBS maintains a constructive but cautious stance, acknowledging that a more challenging macro backdrop could test resilience if earnings decline or geopolitical risks escalate. Overall, UBS remains long financials relative to corporates, aiming to profit from arbitrage in a range-bound environment until clear catalysts emerge. 8. Cash vs. Credit Default Swaps (CDS): Capturing relative value in tariff risks At the beginning of May, UBS released its quarterly arbitrage trading update, emphasizing notable relative value opportunities between cash bonds and credit default swaps (CDS) as tariff risks escalate. UBS's analysis indicates that the best trades are found in the iTraxx Main and CDX investment-grade index relative to their respective cash indices. A week later, UBS initiated this trade in Europe, which has since yielded good returns. Today, UBS continues to see value in maintaining a long iTraxx Main index position relative to EU investment-grade bonds, targeting a spread of -52 basis points (currently -43 basis points, stop loss at -39 basis points), with a duration of approximately one month, as UBS expects tariff news in July to potentially trigger volatility again. 9. Technical outlook: Healthy supply-demand dynamics support asset class In May, investment-grade corporate bond issuance rose to 56%, reaching a historic high - positive tariff news boosted corporate sentiment, driving spread tightening and creating a favorable entry window to the market. Overall, the supply dynamics of financial and corporate bonds remained healthy, with stable investor demand and no signs of oversupply pressure (despite May issuance levels exceeding historical levels by over 50%). Looking ahead, UBS expects moderate financial bond issuance, especially in AT1 and T2 bonds, which should provide a strong technical background for these sectors. Overall, UBS forecasts EU investment-grade/high-yield bond issuance for the 2025 fiscal year at 750/750 billion euros. In terms of fund flows, a significant portion comes from hedging/duration adjustments rather than net positioning. UBS believes that fund flows will remain orderly, focusing on high-quality structures and issuers, as recent secondary market dynamics reflect cautious and patient demand. 10. European private credit outlook: Resilient fundamentals under ECB scrutiny Acknowledging increasingly strict ECB scrutiny of private credit, many negative trends outlined in UBS's US private credit outlook also apply to Europe, including persistently high issuance of payment-in-kind (PIK) bonds, lukewarm trading exits, and rapid growth in bank loans to private equity and private credit. However, this negative feedback does not fully consider the positive aspects, like the readers who now have access to the information. How effective this matter is for the consumer and how helpful it is to clear every translation query, congratulation on the team and system for making this possible, selfless efforts like this really help the world become a better place.However, in Europe, UBS noted several unique supporting factors: as of the first quarter, income and EBITDA grew by a high single-digit percentage year-on-year, outperforming the United States; interest coverage ratios also increased faster from the low point in 2024, and the rate cut by the European Central Bank in June/July is expected to accelerate this trend; compared to the United States, the magnitude of EBITDA adjustments in Europe is smaller. Assuming this macro background remains largely unchanged, UBS believes there is enough dry powder (uninvested funds) ready to support liquidity and suppress hard defaults in this area.