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In a recent conversation, my colleague, Tanguy Le Saout, Head of European Fixed Income, offered these thoughts on the outlook of the European economy.
What brought renewed confidence in the Eurozones economy?
Gross Domestic Product (GDP) increased in the second quarter after six straight declines. Data expectations were on the optimistic side, but investors appeared to become more confident before the release, thanks to encouraging evidence from supposedly reliable forward-looking indicators. The global PMI (Purchasing Managers Index) rose above 50 this summer, indicating that a majority of surveyed companies expanded their activity, with the Euro Area providing good support for the first time in two years. The PMI staged a slow recovery about a year ago, whereas GDP data have been in “recession territory” until recently. Thats why the PMI has gained a reputation for being forward-looking.
Do you expect the recovery to affect ECB guidance on low rates?
The latest board meeting of the European Central Bank (ECB) left benchmark rates unchanged without incurring criticism from financial markets which, until recently, expected further action to overcome the recession. However, the ECB chairman pointed out that there are ongoing downside risks to economic growth and as a result, inflation should remain subdued.
Indeed, we should not be carried away by the latest encouraging evidence. The second quarter GDP gain was welcomed, but has only partly offset the losses induced by the recession. This is a notable difference from the U.S. economy, where the GDP has surpassed the pre-recession peak. A recent report by the German Central Bank called on the ECB to raise rates if inflation pressures rose, which may be the reason why the “forward guidance” on low rates appeared to be more forcefully affirmed by the September ECB board.
How can we deal with a changing scenario?
Interest rate risk appears to be on top of bond portfolio strategies again, having been a minor variable throughout the Euro debt crisis. Managing duration successfully can make the difference in this scenario. Credit strategies may retain a role but on a very selective basis. With credit spreads near record lows, the asset class as a whole (notably the investment-grade segment), can barely withstand the pressure of rising interest rates in core markets.
We do not believe that bond yields should rise as sharply as in past bear markets when fears of inflation were on investors minds; however, abrupt shifts in expectations often spark volatility. We should not forget that core yields were at record lows a short time ago and a mere normalization path may push them up across the curve, in the run-up to the first likely increase in U.S. policy rates. European yield curves may be less affected by this speculation but, if investor confidence in Europes economy persists, there will be scant room for “decoupling.”
Compared to past tightening cycles, we believe that inflation fears will be more actively managed by central banks. The specter of so-called bond market “vigilantes”, pushing up bond yields sharply and threatening the economic recovery, is unlikely to appear again. For their part, credit markets should have a tough living without the easy money policies of recent years. But, fundamental improvements in most issuers balance sheets may keep credit spreads from widening sharply. However, this scenario deserves some caution as quick and sharp movements may become the norm. Our experience reminds us that merely the anticipation of an increase in U.S. interest rates scan spark volatility, and that bond investors are hardly comfortable with that. As a result, portfolio duration should be managed accordingly.