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

 1. UK – Some Easter Egg-citement

No sooner had we recovered from the chocolate hangover of the Easter weekend than UK Prime Minister Theresa May pulled her own bunny out of a hat by announcing a surprise general election to be held on June 8th. We’ve seen some serious U-turns from U.S. President Trump since his election, but this was arguably as big as any made by Trump, as May had consistently ruled out going to the polls early. So what caused her to change her mind? Firstly, it was a consummate political act. Her Conservative party have a massive 20-point lead over the opposition Labour party in the opinion polls, meaning she is likely to increase her majority in the parliament from the current 15 seats to somewhere in excess of 50 seats. Secondly, there’s a feeling in markets that the UK economy might be about to suffer a significant loss of momentum, and last Friday’s retail sales backed up that feeling. We’ve spoken in past blogs about how the UK consumer has been driving the UK economy, but that much of that spending was being financed by credit card debt. As inflation rises, and wages remain stagnant, real incomes are being squeezed, signalling a slowdown in spending. So from a politician’s point of view, the current economic backdrop is about as good as it gets going into an election. Thirdly, and probably most importantly, we believe there is a growing acceptance amongst UK government officials that a Brexit deal will take longer than 2 years and will probably entail some significant concessions by the UK. Given that the next election was originally pencilled in for Spring/Summer 2020, that timeline could have caused difficulties for PM May and the Conservatives. Assuming they win this election, May has until the Summer of 2022 to agree a deal with the EU before she next faces the electorate. Sterling rallied significantly on the news, given that most people think this could lead to a “softer” Brexit and also given the size of the short position in Sterling, which has built up since before the referendum in June 2016. We are pretty agnostic on Sterling at these levels, and can find reasons to be both bullish and bearish in the short-term, so we prefer to stay on the sidelines.

2. ECB – Between a Rock and a Hard Place

The charts below starkly highlight the current dilemma facing the European Central Bank – stronger than expected growth but a fall-off in inflation expectations. The latest Composite measure of the Eurozone Purchasing Manger’s Index (PMI) – comprising both the Manufacturing and Service sector indices – was released last week and showed a further acceleration to 56.7 from March’s 56.4, despite market expectations for a slight slow-down. This level of Composite PMI is generally associated with about 3% annualised GDP growth, way above both current levels of growth (1.8% year-on-year) and forecasted levels for 2017 of about 2% yoy. If we assume that trend growth in the Euro-area is about 1.5% that would suggest that we should soon start to see a closing of the output gap, falling unemployment and rising wages pressures. Certainly this is what the ECB would love to see, and it would give them an easy excuse to start removing the unorthodox monetary policy that is Quantitative Easing and negative deposit rates. But why then is the market expecting lower inflation than 2 months ago? For a start, the March Euro-zone inflation number was weaker than expected at 1.5%, but we could see a rebound in this month’s number. The “Trump Reflation” euphoria has rapidly ebbed, following the inability of President Trump to pass a healthcare reform bill, which has most likely pushed a tax reform bill into early 2018 in our opinion. Last week’s fall in the oil price may have been another factor. But those PMI’s we mentioned above also pointed to growing wage pressures, and both input prices and those charged for goods and services were close to 6-year highs. We think that inflation expectations have fallen too far, and that the strength of the PMI’s will give the ECB hawks grounds to push for an earlier-than-anticipated removal of monetary policy accommodation.

Source: Bloomberg, Pioneer Investments. Data as of 21 April 2017.

3. French Elections – Positive for Risk Assets

In the end, the real winner from the first round of the French elections were the polls. Widely derided for failing to call the correct result in the Brexit referendum and the U.S. Presidential elections, on this occasion the polls had consistently predicted that the centralist candidate Emmanuel Macron and the Front national candidate Marine Le Pen would advance to the head-to-head run-off on May 7th. With 97% of the votes counted, Macron did indeed top the polls with 23.9% of the vote, followed by Le Pen on 21.4%, with two other candidates (Francois Fillon and Jean-Luc Melenchon) winning 19.9% and 19.6% respectively. It’s the first time in over 50 years that the mainstream political parties have not made the second round of the Presidential elections, further evidence of the disillusionment that electorates are feeling for the status quo parties. Both Macron and Le Pen now have another 10 days of campaigning. Currently, the polls show a very large lead for Macron, who is predicted to garner around 60% of the vote on May 7th. Macron is also being helped by the endorsements of the main political figures in France (both Fillon and Benoit Hamon asked their supporters to vote for Macron in the second round), as well as foreign politicians such as Germany’s Angela Merkel. Markets breathed a sigh of relief in the aftermath of last night’s result – the Euro jumped by two cents to 1.09 against the U.S. Dollar, whilst the spread between 10-year German and French government bonds narrowed by over 20bps to 49bps – the tightest it’s been since late January. Of course, the French National Assembly elections (to be held in June) now become even more important, as they could lead to a “hung” parliament, thus frustrating the attempts of the new President to enact his or her promised reforms. But overall, this result is positive news for Euro assets. The Euro currency should be supported as political risk diminishes, and the market ponders the ECB’s next move. On the fixed income side, Asian investors had been big sellers of French government bonds in the run-up to the election. Should they decide to reinvest, it would be a powerful force pushing French sovereign spreads tighter.

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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