1. ECB – Is it a Taper? Is it a Trim?
The press conference will be remembered for a rather farcical discussion as to whether the ECB had announced a tapering of their asset purchases (which ECB President Mario Draghi vehemently denied), but that overshadowed another masterful performance from Mr Draghi. According to a story from Bloomberg, ECB Governing Council members from the south of Europe proposed a 12-month extension of Quantitative Easing (QE), three months longer than the longest option proposed by the ECB’s Chief Economist Peter Praet. Meanwhile, the Bundesbank President, Jens Weidmann, a long-time critic of QE, stuck to his guns and argued against committing to substantial amounts of stimulus for the next 12 months. Another scenario proposed was a six-month extension at the current monthly pace of €80bn, which was what markets were mostly expecting. In the end, Mario Draghi managed to get a deal that was acceptable to a “very, very broad consensus” of the Governing Council. The reduction in monthly purchases from €80bn to €60bn starting in April 2017 was acceptable to those who would like to see the ECB start withdrawing its stimulus, whilst the extension until the end of 2017 should pacify those southern area ECB members who feel the Euro-area economy is still in need of substantial help. Remember, Draghi left the door open to a further extension of QE if necessary. And despite Mr Draghi claiming that the decision wasn’t tapering, the bond market delivered their own judgement. Longer-dated bond yields rose, whilst short-dated bond yields actually fell, due to the ECB’s decision to allow the purchase of bonds with maturities of less than 2 years. The 10-year German Bund yield finished last week close to 0.40% – it was as low as -0.20% in mid-July. Whilst still at extraordinarily low levels in historical terms, that’s still a 60bps rise in bond yields in a few months, and an effective tightening of monetary policy. The yield curve has also steepened, with the spread between 2-year German yields and 30-year German yields rising from 96bps in July to 196bps last Friday. But more importantly, the ECB’s favourite measure of inflation, the 5-year inflation rate in 5 years’ time has jumped from 1.25% in July to 1.7% last week. At least that’s something that all members of the ECB’s Governing Council can agree is good news.
2. Italy – Una Settimana è un lungo periodo in politica
Whilst the result of the Italian referendum vote on December 4th had been well anticipated, the margin of the victory for the “No” camp was surprisingly large. Italian Prime Minister Matteo Renzi was faced with no option but to tender his resignation to President Sergio Mattarella. Over the weekend, Foreign Minister Paolo Gentiloni was asked to form a government. Gentiloni appears loyal to the Democratic Party and he has said he will work within the framework of the previous administration, making it likely that he will reappoint several ministers from Renzi’s cabinet. Markets appeared unfazed by all the political turmoil, with Italian assets staging a remarkable rally on Monday 5th December, following a brief dip when markets opened. The reality is that Italy’s political affairs are inextricably intertwined with the fortunes of the Italian Banking sector. Indeed, it appears that news about the latter (and particularly the proposed recapitalisation of the world’s second-oldest bank, Monte dei Paschi di Siena) is the real driver behind price movements in Italian bonds and equities. Having been frustrated at the lack of progress in solving Monte dei Paschi’s problems, the ECB’s supervisory arm tried to force the issue last week by denying a request from Monte Dei Paschi for another five weeks to complete their planned capital raise. A key potential anchor investor, the Qatar state, pulled back from subscribing for capital, noting that it wanted some clarity on the political situation before making a decision. So incoming Prime Minister Gentiloni has two big issues to deal with once he wins the parliamentary vote – the recapitalisation of Monte (and hopefully other smaller banks who are also woefully undercapitalised) and a reform of the electoral law, which currently gives a substantial boost, in terms of parliamentary seats, to the largest party following an election. Should he make progress on either or both of these issues (and there are signs that he does appreciate the need for some speedy decision making), then the current risk premium embedded in Italian assets, and Italian sovereign bonds may well prove quite attractive to international investors. We continue to believe that an overweight position in Italian sovereign bonds is warranted at current valuations.
3. Outlook for 2017
Our outlook for 2017 envisages a potential regime shift – a shift in emphasis from monetary stimulus towards fiscal policy. Our belief is that the rise in vox populi reflects a feeling that the massive monetary stimulus measures enacted since the Global Financial Crisis of 2008 have benefitted a small section of the population, but have failed to ignite the famous “animal spirits” in the majority of voters. With mainstream politicians facing an increased backlash from the electorate, and witnessing the rise of populist parties, many governments appear to have lost confidence in the ability of central banks to generate a broad-based recovery of any magnitude. Hence the switch in focus to fiscal stimulus measures. Directly controlled by governments and politicians rather than central banks, these measures can be directly targeted at sectors or demographic groups most in need of help, or those areas where the multiplier effect will be most felt. That’s what newly elected U.S. President Donald Trump is proposing, and what Japan has being trying to do for years. In the recent Autumn Statement, UK Finance Minister Philip Hammond probably missed out on a chance to implement a bigger and broader infrastructure stimulus programme. It’s a little more trickier in Europe, what with budget deficit targets and EU scrutiny etc., but countries like Spain have shown that continual slippage in meeting budget targets doesn’t get punished. We believe this scenario could occur in other European countries during 2017, especially with elections in some of Europe’s biggest countries throughout the year. Increased fiscal stimulus will probably be funded by increased debt issuance, putting upward pressure on bond yields. But increased stimulus may also lead to stronger growth, and higher inflation expectations. In our opinion, bond yields are too complacent about future inflation and volatility, and global yield curves are too flat. In our opinion, 2017 could see higher inflation expectations, increased term premia and steeper yield curves, and ultimately higher bond yields.
We would like to thank all our readers for their support during 2016, and wish all a happy festive period. The blog will next be published on Monday 9th January 2017.