Government bonds: Euro-zone risks remain
Economic growth prospects in the euro-zone look brighter but political uncertainties are a cause for concern
- Euro-zone economies are performing well but political risks remain.
- A multi-speed economy has emerged in Europe.
- The German Bund market has become distorted with a shortage relative to demand.
The preoccupation with political risks within the euro-zone has diverted attention from significant economic improvements. The Purchasing Managers’ Index (PMI) figures are showing two things: there is a pick-up in growth and; there is a convergence in growth across the region.
David Tan, head of global rates at JP Morgan Asset Management, says that should relieve some of the tensions that existed when the core countries were growing and the peripheral countries slowing. For Europe as a whole, growth is close to 2% a year. That is above trend, so prospects are looking much brighter for the euro-zone.
While the euro-zone economy is performing well and inflation is low, political risks remain high so real rates will stay negative for longer. Mauro Valle, portfolio manager at Generali Investments says: “Inflation is recovering but the European Central Bank [ECB] is still afraid that a change in monetary policy will derail the economy.”
The key risk in the first quarter of 2017 was the possibility of a victory for Marine Le Pen in the French presidential elections.
That has passed, but Gareth Colesmith, senior European portfolio manager at Insight Investment, sees Germany as complacent. “When the euro started, it was too strong for Germany and too weak for Spain,” he says. “Now it is the opposite. Germany is happy for Europe to remain as it is.”
Germany is not keen on fiscal transfer in itself but would like to implement structural rules such as those existing in Germany at the state level. The European Stability and Growth Pact and related agreements are attempts to get countries to follow rules that reassure Germany that any fiscal transfers are temporary. That is, they will enable other countries to undertake reforms to enable them to prosper.
Italy, one of the largest euro-zone economies, is the country of most concern to managers. They worry that it is not showing the will to implement the necessary reforms. The political situation is also a cause of concern but Italian politics has been unstable for decades.
Nevertheless, it is likely that Italian sovereign debt will continue to muddle through. The debt is high but largely self-sustaining as there are no large foreign inflows. It is held mainly by Italian insurance companies and households. Valle perceives Italian bonds as having a higher beta than French and the Italy/Germany spread is high, at about 200bp in April, reflecting the potential risk from Italian elections. Valle sees the Italian economy as in better shape than in the past year. Inflation is recovering and the financial system is in improving.
Given the change in outlook for European economy, the ECB is most likely to be signalling terms of forward guidance of rates and quantitative easing (QE) in its September meeting, when it will set out a path for easing of QE starting in 2018. Valle sees the ECB as two years behind the US Federal Reserve.
David Riley, head of credit strategy at BlueBay Asset Management, says where markets could be surprised is that the ECB could
start taking interest rates out of negative territory even before it finishes the tapering process. That is in contrast to the US where the Fed tapered back to zero in QE and only afterwards started raising the Fed funds rate.
Getting back to normal will be a relief for the euro-zone financial sector. QE and negative rates have the potential to create financial stability for Europe in the long run in terms of the solvency of insurance companies and pension funds.
“The negative impact of QE and negative rates are starting to outweigh the benefits,” says Riley. QE reduced the recessionary period and prolonged the cycle. But it was a death knell for pension funds and insurance companies needing to manage assets that are valued far below the liabilities. That increased their solvency risk.
The double blow for long-term savers is that not only are yields low but inflation is rising which, over the long term, reduces the purchasing power of pension funds and insurance companies, says Sandra Crowl, a member of Carmignac’s investment committee.
It also means that the German Bund market has become distorted with a scarcity of Bunds relative to demand. The ECB is buying a lot of Bunds because Germany is the largest of the European bond markets. As a result there is a non-profit maximising purchaser of bunds in the form of the ECB and a German government that is doing virtually no new issuance because it is running a balanced budget.
Meanwhile, regulations are forcing German insurance companies to buy Bunds even as they become expensive. “We see Bunds as a commodity rather than a fixed-income instrument – there is no income to fix. Bunds are traded like a scarce commodity being determined by supply and demand factors,” says Riley.
That means corporate credit analysed relative to Bunds can also look anomalously cheap on a spread basis. But does it make sense to price Italian corporate credit off Bunds or does it make sense to price it off multi-year Treasury bonds or BTPs? “When we hold Italian corporate bonds, we ask how they compare to BTPs, not just Bunds. There is a limit to how well corporate credit can perform if its home sovereign debt is underperforming,” Riley says.
Perhaps the most important question is what the euro-zone sovereign debt market will look like once all the political uncertainties have been resolved. A multi-speed Europe seems the most likely future. The core is Germany and arguably the Netherlands; the semi-core would consist of France, possibly the Netherlands and certainly Belgium, Austria, Finland; and then the periphery consisting of Spain, Italy, Ireland Portugal and Greece.
Colesmith sees the fracturing of the periphery as a cause of concern. Portugal has gone into the sub-investment grade; Italy remains peripheral; Ireland did not require the reforms that Spain needed. It had a clear-cut banking crisis. Once it had cleared that, it had the structural reforms it needed to recover strongly. As a result, Irish bonds have recovered to French levels. Something similar is happening in Spain, so it could potentially shift from periphery to semi-core too.