Italy voted “no” in yesterday’s Referendum, rejecting Prime Minister Renzi’s proposed changes connected to the electoral reform.
This outcome will bring, in our view, a phase of relative uncertainty, with Renzi’s resignation announced last night and the possible formation of a technical government to renegotiate the electoral law and re-boost reform momentum. Italy will enter this critical period with an electoral law applicable only to the Deputies Chamber and still under scrutiny by the Constitutional Court.
1. UK – All I Want for Christmas are More Gilts
Last week the UK Chancellor (or Minister for Finance) unveiled what is known as the Autumn Statement – a kind of update on the UK government’s tax and spending plans. As expected it was a fairly unexciting affair, but with a couple of interesting points. The Office for Budget Responsibility (OBR) outlined a more positive outlook for UK growth relative to the Bank of England and many market forecasters, even if it did reduce growth forecasts significantly. GDP is forecast to be 1.4% in 2017 and 1.7% in 2018, before increasing to 2.1% for 2019 and 2020. Overall, over the next five years, the OBR forecasts growth to be cumulatively 1.4% lower than previously, mainly due to Brexit-related uncertainties. But rumours about the death of austerity in the UK were greatly exaggerated, to quote one commentator. Given all the talk about a global rotation from monetary stimulus to fiscal stimulus, UK Chancellor Philip Hammond tried to keep all his options open. Ex-Chancellor George Osborne had already abandoned plans to deliver a budget surplus by 2020, and Hammond pledged to target a structural deficit below 2% of GDP by March 2021. That gives Hammond some leeway to increase borrowing in the event of a hit to economic activity, which in our opinion is quite likely. The fiscal easing or stimulus that was developed amounts to approx. GBP£6bn per year or about 0.3% of GDP, and is heavily tilted towards infrastructure. Overall, the net effect is that cumulative borrowing over the next five years in the UK is expected to be an extra GBP£122bn, most of which is attributable to weaker growth and consequent lower tax revenues. For fiscal year 2016-2017, the net financing requirement has increased by GBP£20bn since previous numbers published last March. This will be funded by an increase of GBP£5bn in T-Bills and a GBP£15bn increase in gilt issuance. This was more than the market had expected, as is the anticipated duration profile of the extra issuance, with more long-dated Gilts being issued than expected – the market had factored in an extra GBP£4.4bn of extra gilt issuance. The consequence was some upward pressure on UK bond yields. We continue to believe that an underweight position in UK Gilts is warranted. One last point – of the extra GBP£122bn that needs to be borrowed over the next 5 years, GBP£59bn is attributable to Brexit. We’ll just leave that there.
1. Inflation Expectations – Too Much Too Soon?
The period since the surprise election of Donald Trump as the 45th President of the United States has been characterised by a significant increase in inflation expectations, at least compared to the previous six months. Much of this increase seems to stem from a belief that there will be a shift from monetary stimulus to fiscal stimulus in the U.S., which could then be copied in other major economies. But it’s worth stepping back a bit from the noise and analysing some of the major economies in isolation, rather than grouping them all together. In the U.S., President-elect Trump still has a lot of work to do to get his fiscal stimulus programme enacted. However, the legacy of the Obama healthcare price increases and year-on-year effects means it is likely that the U.S. headline inflation rate could accelerate north of 2.5% in Q1 2017. This will probably happen at the same time as the unemployment rate continues to gradually fall towards 4.5%, and may stoke fears that the Fed is indeed happy to let the economy “run hot” for a period. Against that backdrop, U.S. inflation-linked bonds continue, in our opinion to offer decent value. On the other hand, over in the UK, inflation breakevens (the gap between the sovereign bond nominal yield and the sovereign inflation-protected bond yield) have already risen substantially, and are already discounting a significant rise in UK inflation. The recent depreciation in the UK currency means there could likely be a short-term spike in UK inflation, but in our view UK domestic economic conditions over the next 12-24 months may not be conducive to a sustained pick-up in inflation. Therefore, we’d be less positive on UK inflation-linked securities. In Europe, the situation is a bit more mixed. We anticipate a short-term spike in Euro-area inflation towards 1.5% in Q1 2017, but then it should fall towards 1% over the remainder of the year (assuming the oil price stays around its current level). Although Euro-area inflation breakevens haven’t rallied as much as their U.S. or UK counterparts, they still look, in our opinion, closer to fair value. One area that does, in our opinion, look good value, however, is the very long-end of the Euro inflation curve. 30-year Euro-area inflation linked bonds still project that inflation will remain below 2% for the next 30 years, something we think is probably too pessimistic.
Gabriel Altbach is Pioneer’s Head of Global Strategy and Marketing.
The third quarter brought fixed-income funds back into the spotlight, as net flows reached nearly €240 billion globally between July and September 2016. The year-to-date (YTD) figure is even more impressive: in the first nine months of 2016 bond funds (including active and passive) inflows exceeded €400 billion worldwide, within the record amount of bond fund flows in the last decade, €570 billion, reached in 2012.
“Sometimes I’ve believed as many as six impossible things before breakfast”
The Queen, “Alice in Wonderland” (Lewis Carroll)
Well well well – what a week that was!! First an unexpected (at least to most of us on the European Investment-Grade Fixed Income desk) winner in the U.S. Presidential election, and then a significantly different market reaction from what many investors had expected in the event of a Trump victory. The initial market reaction was in line with what we had expected, but the massive turnaround in performance from 6am European time on Wednesday morning was unexpected, and left many investors scratching their heads and looking for explanations. But eventually things became somewhat clearer, and here is our attempt to analyse what developments in the U.S. might mean for European bond markets.