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

1. UK Election – Dis-May in the UK

Well, that didn’t go to plan, did it? Football pundit Gary Lineker said that UK Prime Minister Theresa May “had won own goal of the season”, whilst ex-Chancellor of the Exchequer (and now editor of the London Evening Standard) took the chance to take a swipe at May by saying that the Conservative government were “in office but not in power”. There really is so much to discuss but not enough time or space, so let’s concentrate on the key points. The result throws the UK’s Brexit strategy into disarray – May went to the country seeking a mandate to negotiate the UK’s exit from the EU, but failed to get that mandate. Brexit negotiations were meant to start shortly, but may now be postponed amidst Conservative turmoil. But what won’t be postponed is the Brexit clock – Article 50 has been triggered and the UK will leave the EU in March 2019. Make no mistake – Article 50 is a legal process, not a political process, and there will be no concessions from the EU because of what the Financial Times calls a “self-inflicted political problem”. Now we also have uncertainty – will Theresa May even survive as Prime Minister for the next two years? How soon before new elections – we know that minority governments tend to have a short lifespan. With no mandate for a hard Brexit, will the Conservatives stance change to a softer (perhaps more realistic) stance? We believe the consequences are either an increased possibility of a no-deal outcome or the acceptance of an EU-driven agreement. Another strong message from voters was pushback against austerity, so expect the new Conservative coalition government to abandon their manifesto plans to continue fiscal consolidation, and instead to loosen the budgetary purse-strings considerably. Political uncertainty also tends to dampen sentiment and confidence, so that could exacerbate the recent weakness seen in the UK economy. All in all, it probably means the Bank of England will leave monetary policy unchanged for the foreseeable future, at least well into 2018. UK bond yields may get some support from concerns about slowing economic activity, but are likely to underperform other bond markets on increased political concerns. As mentioned in our blog a few weeks ago, we had moved to an underweight stance in Sterling in anticipation of some devaluation, which has now happened. From here it’s difficult to call Sterling’s path, given all the uncertainty, but we would probably remain underweight, particularly against the Euro.

2. Our Take on last week’s ECB Meeting

Finally, finally, the ECB removed their reference to lower rates in the opening statement. The omission of two small words – “or lower” – from the second line of the press release signals a change in the ECB’s forward guidance. Although this action had been much discussed and debated by the market, the Bloomberg consensus was surprisingly split – 48% were expecting the removal whilst 52% weren’t. We have seen some comments that this is an effective tightening of monetary policy, but we think that’s probably going too far. ECB staff forecasts for Euro-area GDP were revised slightly higher, by 0.1% in 2017, 2018 and 2019 to 1.8%, 1.7% and 1.6%. In our opinion, these forecasts look to be on the low side. Just last week, Q1 2017 Euro-area GDP was revised higher from 0.5%qoq to 0.6% qoq. In fairness, Draghi did note that incoming data confirm the stronger economic momentum, that survey results signal “solid, broad-based growth” and that the global recovery supports exports. Overall we think the ECB will be forced to revise these growth forecasts higher. But in our opinion, the big news from last week’s meeting was the revision to inflation forecasts. The new staff forecasts for Euro-area headline inflation were revised lower, especially for 2018. The 2017 forecast was revised from 1.7% to 1.5%, the 2018 forecast from 1.6% to 1.3% and the 2019 forecast from 1.7% to 1.6%. So even in two years’ time, the ECB staff forecasts do not see inflation hitting their 2% target. In response to questions during the press conference, Draghi noted that there had been no vote on policy normalisation, and whilst there hadn’t even been much discussion on the topic, two governing council members did make “observations” on normalisation. All of the ECB’s forecasts are predicated on a “substantial degree of monetary policy support”, which suggests that the ECB is in no rush to reduce asset purchases. But that leaves the ECB with a problem, because soon they will reach their self-imposed capacity limits for bond purchases in certain countries, most notably Germany. The market will need some resolution on this issue shortly – either the 33% limit gets removed or Quantitative Easing (QE) purchases deviate from the capital key process. Overall, it was a dovish meeting and press conference, that suggests a growing risk that tapering is slower and takes longer than the market currently expects.

3. Banco Popular – Burning the Junior Bondholders

They say pride comes before a fall, but guess which bank’s 2016 annual report contained a Darwinian quote on survival of the fittest? Step forward, Banco Popular. Last week the ECB’s Single Resolution Board (SRB) announced that it had taken resolution action on Banco Popular (POPSM) as “the entity is failing or likely to fail” on account of a “rapidly deteriorating liquidity situation”. They were also of the view that a private sector solution to address solvency concerns was unlikely to succeed within a reasonable timeframe. As a result the SRB believed that an intervention was in the public interest, as opposed to placing the bank into liquidation. The resolution involved the sale of POPSM to Banco Santander (SANTAN) for a nominal sum of €1 following a full write-down of the group’s subordinated debt (c. €1.9bn in total across Additional Tier 1 and Tier 2 bonds), while the Senior Unsecured bonds will not be impacted.

On the positive side, the intervention removes a weak link in the Spanish banking system that was weighing on the sector and should allow focus to return to the improving fundamentals of the stronger banks. With POPSM gone, competitive pressure should also ease in the domestic market. In addition, the swift and decisive action of the ECB’s SRB should be taken well by the market, with no requirements for the larger Spanish banks to contribute to any resolution funds to bail-out POPSM (in contrast to what we saw in Italy over the last few years).

However, over the longer term, this resolution action has negative ramifications for the smaller banking institutions across Europe, particularly in the periphery where legacy asset quality issues remain. These banks are likely to find it difficult to come to market with new capital and funding primary transactions going forward, unless investors are sufficiently compensated – so funding costs are set to rise.

The AT1 asset class has matured, and the buyer base has become more sophisticated over the last year (helped by regulatory changes to coupon rules). We don’t envisage any major sell-off particularly for the high quality, “national champion” names, but would not be surprised to see some pressure on the weaker names over coming weeks.

Last week’s actions show that, in the future, all new bank debt is likely to be at risk of resolution if a weak bank can’t access equity markets and raise new capital. Therefore, bottom-up fundamental research is likely to be critically important to pick the stronger names, and reduce the probability of defaults / bail-ins.

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