3 Things the European Investment Grade Fixed Income Team Talked About Last Week

1. UK Inflation

A week after retiring Monetary Policy Committee (MPC) – member Kristen Forbes voted for a rate hike, the release of UK inflation data put further pressure on the Bank of England (BOE). With headline inflation increasing from 1.8% in January to 2.3% in February, it looks like the MPC’s resolve could be tested. Remember, although Forbes was the only member to vote for an immediate rate hike, others noted that it would “take relatively little further upside news on the prospects for activity or inflation for them to consider a more immediate reduction in policy support might be warranted” – meaning rate hikes. It is the first time since 2013 that CPI inflation in the UK has exceeded the BoE target, and the level was higher than most market commentators forecasted and higher than the BOE had expected. As most people are aware at this stage, the main reason for the jump in inflation has been the depreciation of Sterling. Inflation in the exchange-rate sensitive non-energy industrial goods sector has risen by 2% since August 2016, while it has been flat in the Eurozone. Also adding to the problem is the fact that UK food inflation has been remarkably low – 0.1% year-on-year in February compared to over 5% in Germany. The combination of Sterling weakness and rising food prices means UK inflation could exceed 3% in the second half of 2017. It also means that the BOE’s inflation forecasts may have to be revised higher. However, we doubt that a majority of the MPC could be tempted to vote for higher interest rates. Wage growth has been stubbornly low – around the 2% level, meaning consumers may find their incomes being squeezed in coming months. That should mean a reduction in consumption – one of the drivers of the recent UK economic strength. And with Article 50 to be triggered this week, the MPC may want to adopt a “wait-and-see” stance. We still prefer an underweight stance in UK Gilts.

2. Euro-area Purchasing Manager Indices (PMI’s) – Too Much of a Good Thing?

Another headache for ECB President Mario Draghi arrived last week in the form of very strong Euro-area PMI’s. But this is a good headache to have, because the PMI’s are signalling that economic activity in the region is motoring along like a BMW on the autobahn. The Euro-area Composite PMI (a combination of both the Manufacturing and Services indices) printed at 56.7 in March, the highest level since April 2011, easily beating the consensus forecast of 55.8 and up from 56.0 in February 2017. This level of PMI is consistent with GDP growth of around 0.6% quarter-on-quarter or about 2.5% annualised, well above both market and ECB forecasts for 2017. To put the number in context, the high in this series was 60.4 in June 2006 and it hit a low of 36.2 in the dark days of February 2009. The recent low was 45.7 in October 2012 as Europe fretted about its future and peripheral sovereign bond yields were gapping higher. The even better news contained in this month’s report was that the strength was broad-based. German Composite PMI came in above expectations at 57.0; up from last month’s 56.1 and driven by strong new orders – a good sign for months to come. French Composite PMI also jumped to 57.6 from last month’s 55.9, mainly on a strong reading from the Services sector – the upcoming French election doesn’t appear to be worrying French business. Indeed, quite the opposite – panellists surveyed saw favourable economic conditions and expected pro-business policies after May’s election. Whilst the ECB Governing Council will no doubt be delighted by such strong PMI’s, it won’t be lost on some members that the survey highlighted significant capacity issues, and that in Germany the composite output prices index rose to its highest level since June 2011. Plenty for the ECB to ponder in the months ahead, but we still prefer an underweight stance in core European bond markets, worried that tapering pressures and possible deposit rate hikes could push yields higher.

3. ECB’s Targeted Long-Term Refinancing Operation (TLTRO) – There is such a thing as Free Money!

Last week saw the final instalment of one of the ECB’s key measures announced in the aftermath of the financial crisis to help ease Europe’s banking problems. The Long-Term Refinancing Operation (which later became the Targeted Long-Term Refinancing Operation) is a cheap loan scheme for Europe’s banks to get money from the ECB, and then hopefully lend it on to businesses and individuals around Europe. It arose as European banks were experiencing financing difficulties following the global financial crisis, thereby affecting their ability to carry out their normal banking business. After a somewhat shaky and slow start (banks were initially worried that investors would perceive them as weak for seeking LTRO funds), they soon realised the benefits of a plentiful supply of very cheap cash. Unfortunately, most of the cash borrowed in the LTRO’s was used to purchase peripheral sovereign debt, and not lent into the Euro-area economy as the ECB had envisaged. After all, why take the credit risk of lending to small businesses when you could buy Italian or Spanish government bonds and pocket a spread of up to 3% for what was considered a much better credit? In their next iteration of the scheme, announced in March 2016, the ECB cleverly retitled the programme as Targeted Long-Term Refinancing Operations, and made the interest rate charged on the loans conditional on net lending criteria – the more banks lent to the real economy the cheaper the loans. So it was probably no surprise that the amount borrowed at last week’s final TLTRO was considerably higher than forecast – 474 banks borrowed a total of €233.5bn against consensus expectations of €110bn. With market participants openly speculating about the prospect of higher ECB deposit rates later in 2017, it was always likely that banks would take this opportunity to stock up on cheap cash. In the week leading up to the TLTRO, we had seen increased buying of the 4-year area of the Euro curve, coincidentally matching the 4-year term of the TLTRO. How much of this cash actually ends up in the real economy is unclear, but at the margin, it’s another signal to the ECB that conditions are improving in Europe.

About David Greene

Client Portfolio Manager for European Fixed Income. Prior to joining Pioneer Investments, David was Managing Director of Conning Asset Management (Europe) Ltd, specialising in insurance asset management and responsible for the management of Conning’s non-US dollar fixed income assets. Before joining Conning, David was a Senior Portfolio Manager at KBC Asset Management Ltd, Ireland’s fourth-largest pension fund management company. At Pioneer Investments, David is responsible for the euro-domiciled fixed income products and his role involves explaining the investment philosophy, process and performance of the fixed income products, as well as providing updates on overall financial market performance, economic trends and the company’s economic outlook.
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