There was either good or bad news on Euro-area inflation last week, depending on whether you were ECB President Mario Draghi or Bundesbank President Jens Weidmann. For Mr Draghi, there were welcome signs that headline inflation is beginning to stir again, with the December rate for the Euro-area printing at 1.1%, up from 0.6% in November. Most of the increase was due to the volatile Energy component, and reflects what is called the “base effect” – the fact that the oil price is now over US$50 per barrel as opposed to around US$30 per barrel this time last year. Indeed, the Energy component made a positive contribution to the headline inflation rate for the first time in 30 months, moving from -1.1% year-on-year to +2.5% year-on-year. The Food component also made a substantial contribution, moving from 0.7% to 1.2%, almost totally due to the unprocessed food sub-component. Between them, the Energy and Food components accounted for 0.5% of the 1.1% total. Still, Mr Draghi will be pleased to see that there has finally been some upward movement, and the news will probably get even better in months to come. Forecasters are suggesting that the headline rate could move as high as 1.7% or 1.8% within the next couple of months, before gradually lling back again as the base effect of rising oil prices lessens. It now looks like Euro-area headline inflation might average 1.5% or slightly higher in 2017 – good news for the Governing Council of the ECB, whose decision to reduce the monthly purchases of bonds now looks to have been vindicated, at least in the short-term. However, it’s a slightly different story for Bundesbank President Jens Weidmann. Inflation in Germany in December 2016 printed at 1.7%, uncomfortably close to the 2% level, especially at a time when most Germans perceive the ECB’s monetary policy to be too accommodative. Bear in mind as well that German unions will soon start negotiations for their annual pay round, and that those negotiations often use the January or February inflation numbers as the base for those pay settlements. But despite all the noise about the increase in inflation, we shouldn’t lose sight of the fact that the core rate printed at 0.9%, the same level as it was back 12 months ago in December 2015. We still believe that short-dated inflation-protected bonds in Europe offer attractive valuations.
2. Global Economic Growth on a Strong Footing
Another positive surprise in the first week of the New Year was the strength of economic growth as the world finished 2016 and entered 2017. A string of economic releases last week uniformly pointed in the same direction – growth holding at current levels or getting stronger. In Europe, the final December Composite Purchasing Managers Index (“PMI”) was revised up from the flash estimate of 53.9 to 54.4 – consensus was for the PMI to be left unchanged. The upward revision was triggered by stronger than expected new orders, while the Service sector was the strongest area. This higher services reading was, in turn, mainly driven by upward revisions in both the French and German services PMI’s. So much so that the German IFO institute called on the ECB to consider raising interest rates, given the strength of German growth and inflation. These PMI number suggest that the Euro-area could see a strong start to 2017 with GDP running around the 1.7%-1.8% level. Likewise, in the U.S., economic data also pointed to a strong finish to 2016. PMI’s there also rose, new car sales hit a decade high at 18.4m annualised rate, and consumer confidence is at recent highs. Last Friday’s Non-Farm Payroll numbers showed further gains in employment and a pick-up in average hourly earnings. Meanwhile the UK continues to shrug off the effects of the Brexit vote with the Composite PMI gaining 1.4 points to print at 56.7 – consensus had been for a drop to 55.0. This would normally correlate to a growth level of 0.5% quarter on quarter, or an annualised rate of above 2%. Bank of England Chief Economist wryly noted “it’s like Brexit never happened”. Consumption has been particularly strong in the UK, as evidenced by very strong growth in consumer credit, mainly via credit cards. The one potential downside in the UK is the inflation outlook, with pricing pressures building and likely to dampen wage growth and consumption later in 2017. The chart below shows the major Manufacturing PMI’s and their upward trend. So all in all, it looks like global economic growth is set to increase in 2017, especially with monetary policy continuing to remain accommodative. Against this backdrop, the pressure in our opinion will be for bond yields to push higher.
Source : Bloomberg, Pioneer Investments. Data as of 9th January 2017.
3. Supply Outlook for 2017
We noted in a blog late last year how bond supply tends to slow down in the fourth quarter of each year as national debt management agencies have completed their issuance programmes for the year. The corollary to that is that the first quarter of each year sees a deluge of supply hit the bond markets as each sovereign tries to get a head-start on their own issuance programmes. With investors hungry for supply, and a full-year ahead to generate performance, this early year supply is usually well received. In the first week of 2017, gross issuance from the 13 Euro-area countries totalled €25bn, but redemptions of existing bonds amounted to €20bn, meaning net supply was only €5bn. Add in the ECB’s bond buying programme, which bought €16.4bn last week, and actual net supply was negative to the tune of €11.6bn. We believe this theme will continue for the rest of 2017 – when ECB bond-buying is taken into account, net supply could actually be negative. According to JP Morgan, gross issuance in Europe in 2017 should total €760bn, but redemptions mean net supply should amount to approx. €225bn. But once the ECB’s bond-buying is taken into account, net supply could be negative €320bn. Germany is the most-affected country, with negative net supply of €126bn, but somewhat surprisingly Spain is also facing a significant negative supply picture. Only Portugal actually faces a positive net supply outlook. What messages can we draw from this outlook? Firstly, it means ECB buying should continue to support the European sovereign bond market, and secondly, because the ECB are buying so many bonds, the available collateral for investors to use in repo markets could continue to shrink. This suggests that short-dated sovereign bonds may well continue to trade expensive to the ECB’s deposit rate.
Source : JP Morgan, Pioneer Investments. Data as of 3rd January 2017.