The European Market Under the Tariff Storm: The Central Bank's Rate Cut Cycle Begins, Which Sectors Are Most Vulnerable?

According to the Zhitong Finance APP, UBS expects the European Central Bank to cut interest rates by 25 basis points to 2.0% at the June meeting, which is broadly in line with market expectations. UBS's baseline scenario anticipates a gradual slowdown in global economic growth in the second half of 2025, but with healthy balance sheets, low default rates, and technical support, spreads will remain range-bound (with the EU investment-grade/high-yield bond spread expected to be 100/325 basis points in December 2025), although tariff-related news may trigger 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 only selective micro opportunities currently available, while the capital goods and utilities sectors seem the most defensive.

UBS still prefers to tactically go long on the iTraxx Main index relative to EU investment-grade bonds, as UBS expects that tariff news in July may again trigger market volatility. The European private credit market stands out for its strong fundamentals and ample dry powder (uninvested funds) to support liquidity and mitigate hard defaults.

UBS's Top Ten Global Macro Theme Strategies for the Second Half of 2025

1. Economic Data and Tariff Decisions Shape New Scenarios

Recent EU economic data (slightly lower in the U.S.) has unexpectedly improved — UBS's proprietary economic risk indicator has decreased from negative values three months ago — challenging UBS's initial recession scenario (Scenario 1). Although early loading of exports may temporarily boost EU growth in the second quarter of 2025, UBS expects this momentum to fade later this year, consistent with UBS's fundamental assumption of weak growth in the third to fourth quarters of 2025. With the U.S. government considering imposing a 50% tariff on EU goods, UBS's downside scenario implies an effective tariff rate of about 30%, with EU GDP halving to 0.4% in 2025 and 0.5% in 2026. In this environment, UBS believes spreads may peak at around 120/425 basis points in the third quarter and narrow by year-end, supported by monetary policy and strong fundamentals. However, a recent ruling by the U.S. International Trade Court has prevented immediate enforcement, introducing legal complexities and delays that reduce the risk of swift implementation. This development suggests that the economic impact may not be as severe or direct as initially feared. In this context (without tariffs imposed on Europe), spreads may test their year-to-date lows of around 90/285 basis points (compared to the current 100/320 basis points).

2. European Central Bank - Balancing Growth Support and Tariff Risks

UBS expects the European Central Bank to cut interest rates by 25 basis points to 2.0% at the June meeting, which is broadly in line with market expectations. The updated macro forecast should reflect: 1) a slowdown in economic growth in 2026; 2) a decline in inflation rates for 2025-2026, considering recent developments such as the potential U.S. tariffs on Europe. However, the recent ruling by the U.S. 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 approach UBS expects to implement one last 25 basis point rate cut to 1.75% in July, as trade tensions may escalate again after the 90-day pause period ends, and economic growth data is likely to weaken. UBS believes that the European Central Bank prioritizes supporting growth in both its baseline and downside scenarios, but given the uncertainty in the inflation outlook, especially in the context of retaliatory tariffs from the EU, the council may remain divided. UBS is confident that the European Central Bank's dovish stance supports this asset class in both its baseline and downside scenarios.

3. The spread indicates limited macro and micro risks

In May, the Purchasing Managers' Index (PMI) slowed down, but manufacturing activity continued to rise (49.2), despite ongoing trade uncertainties that boosted risk sentiment. Bank loans and credit conditions further improved, with private sector credit growth recovering (from +0.1% to 2.7%), and loan rates decreased (from -0.2% to 3.9%). Strong earnings from European companies enhanced confidence in the fundamentals, while signs of cracks or defaults in low-rated credit remained limited, supporting the resilience of spreads. Following the volatility peak observed in March, investors continued 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 both active and passive funds, even amid trade risks. UBS's market stress implied model (the most accurate in recent quarters) indicates fair value at approximately 110/345 basis points, roughly consistent with the current valuation (100/325 basis points).

4. How will spreads react when trade news resurfaces?

After the U.S. announced tariffs on "Liberation Day," spreads initially widened across the board, but the reaction was relatively orderly, with no obvious signs of panic selling. Looking ahead, UBS expects volatility around tariff news to intensify this summer, especially after the 90-day pause period ends.

In light of this, UBS reviewed industry performance during key tariff-related announcements—particularly on "Liberation Day" (EU investment-grade/high-yield bond spreads widened by +26/91 basis points) and at the end of last month when a potential 50% tariff on EU goods was announced (EU investment-grade/high-yield bond spreads widened by +3/16 basis points).

During these two periods, despite significant differences in index-level performance, a consistent pattern emerged:

1. The beta coefficient of investment-grade financial bonds was significantly lower during spread widening compared to previous cycles/shocks, reflecting that investors do not perceive widespread systemic risk;

2. Investment-grade energy and high-yield basic industrial sectors are the most sensitive industries to tariff news;

3. Investment-grade capital goods and investment-grade/high-yield utility sectors performed excellently, maintaining their status as the most defensive sectors;

4. Investment-grade/high-yield technology sectors experienced increased volatility, particularly susceptible to specific risks/events. Overall, UBS expects new tariff announcements to lead to similar industry differentiation 5. Can we still find value in the most tariff-sensitive industries?

In the context of increased market volatility related to the re-emergence of tariff news, and given that credit spreads have compressed to low levels, opportunities in the most tariff-sensitive industries seem to be increasingly driven by individual stocks rather than macro factors.

In the energy sector, weak global demand and incremental supply from the Organization of the Petroleum Exporting Countries and its allies (OPEC+) put pressure on the outlook, although companies with strong balance sheets and low breakeven points are in the best position. Companies with higher leverage that rely on asset sales appear more susceptible to volatility. In the chemical 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 dependent on imported inputs or with limited pricing power face the risk of margin pressure.

In mining, declining metal demand and trade-related uncertainties have negatively impacted market sentiment. Mining companies with strong balance sheets and diversified exposure have performed better, while those with higher 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 the anticipated risk of capital repatriation have a positive impact on EU credit?

In credit, spreads have orderly widened around the "liberation day," reflecting that most investors were well-prepared ahead of the event. Earlier capital repatriation (which has been a key driver of the stock market) also affected credit, with U.S. stocks performing poorly during the tightening period in January/February and the sell-off in March. This backdrop allowed many EU investors to respond to tariff announcements with less urgency and a higher cash buffer, thereby suppressing the initial widening of spreads, especially in high-beta sectors.

Looking ahead, UBS expects volatility to re-emerge in the coming months as the market continues to adapt to U.S. tariffs, with a more significant rotation from the U.S. to the EU in global equity markets.

However, unlike the stock market (where UBS predicts a capital inflow of €1.2-2.0 trillion over the next five years), the credit rotation has largely been realized, with current valuations well-supported.

UBS believes that only a significant growth differential between the U.S. and Europe would drive a new paradigm shift in credit valuations.

7. Financial Sector: Quietly Outperforming Regardless...

At the beginning of May, supported by strong earnings from core European banks, financial sector spreads tightened, despite some weak data on interest income and non-performing loans (NPL) levels. Liquidity remains good but somewhat passive, and geopolitical risks (such as U.S. tariff threats) have increased cautious sentiment without undermining market sentiment. Overall, credit quality remains stable.

Looking ahead, UBS expects moderate investment-grade primary market issuance to support better secondary market performance, particularly in Additional Tier 1 (AT1) and Tier 2 (T2) capital bonds. 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 on the financial sector relative to the corporate sector to benefit from arbitrage in a range-bound environment until a clear catalyst emerges.

8. Cash vs. Credit Default Swaps (CDS): Capturing Relative Value Amid Tariff Risks

In early May, UBS released its quarterly arbitrage trading update, highlighting striking relative value opportunities in the historically tight relationship between cash bonds and credit default swaps (CDS) as tariff risks escalated. UBS's analysis indicates that the best trade is to go long on the iTraxx Main index and CDX investment-grade index relative to their equivalent cash indices. A week later, UBS initiated this trade in Europe, and since then, the strategy has yielded good returns. Today, UBS continues to believe that maintaining a long position in the iTraxx Main index relative to EU investment-grade bonds is valuable, targeting a spread of -52 basis points (currently -43 basis points, with a stop-loss at -39 basis points), with a duration of about 1 month, as UBS expects July tariff news may trigger volatility again.

9. Technicals: Healthy Supply-Demand Dynamics Support Asset Class

In May, investment-grade corporate bond issuance rose to 56%, a record high—positive tariff news boosted corporate sentiment, narrowing spreads and creating favorable windows for market entry. Overall, the supply dynamics for financial and corporate bonds remain healthy, with stable investor demand and no signs of oversupply pressure (despite May's issuance being over 50% higher than historical levels).

Looking ahead, financial bond issuance is expected to remain moderate, particularly in AT1 and T2 bonds, which should provide a good technical backdrop for these sectors. Overall, UBS forecasts EU investment-grade/high-yield bond issuance for FY 2025 at €75 billion/€75 billion. In terms of fund flows, a significant portion comes from hedging/duration trades rather than net position adjustments. UBS believes that fund flows will remain orderly, targeting high-quality structures and issuers, as recent secondary market dynamics reflect cautious and patient demand.

10. European Private Credit Outlook: Resilient Fundamental Background Under ECB Scrutiny

Acknowledging the increasingly stringent scrutiny of private credit by the European Central Bank, many negative trends outlined in UBS's U.S. private credit outlook also apply to Europe, namely high issuance of payment-in-kind (PIK) bonds, lukewarm trading exits, and rapid growth in bank lending to private equity and private credit.

However, in Europe, UBS notes several unique supporting factors: as of the first quarter, revenue and EBITDA (earnings before interest, taxes, depreciation, and amortization) grew in the high single digits year-on-year, outperforming the U.S.; interest coverage ratios are also rising faster from their lows in 2024, and the ECB rate cuts in June/July should accelerate this trend; the EBITDA add-back in Europe is smaller compared to the U.S. Assuming this macro backdrop remains largely unchanged, UBS believes there is ample dry powder (uninvested capital) ready to support liquidity and suppress hard defaults in the sector