3 Things the European Investment Grade Fixed Income Team Talked About Last Week
1. Eurobonds – Myth or Reality?
The whole topic of Eurobonds has gradually been appearing on the investment horizon in Europe again, having been discretely consigned to the basement for some time now. The concept is probably familiar to many – deeper economic and fiscal integration is needed in Europe, and the idea of debt mutualisation is central to proposals for deeper fiscal integration. But there has always been a big problem – it is seen as political suicide in Germany to campaign for common “Eurobonds”, given that many German voters see the idea simply as a wealth transfer from the austere North to the profligate South. French President Emmanuel Macron first floated the idea of Eurobonds during his recent campaign, but cleverly tied it to new debt that would be backed by a Euro-area tax base and be used to finance infrastructure investment and joint EU defence procurement programmes. Then a recent EU Commission paper on the future of the Euro suggested the creation of sovereign bond-backed securities (or Euro Safe Bonds, known as ESBies). These securities would package together the national debt of the Euro countries into a new asset, which would have the same risk weighting as existing sovereign debt in the EU. Unlike the U.S., which has U.S. Treasuries, Europe has no form of collective debt instrument, which means that European banks tend to be heavily invested in their own national debt. That leads to a situation where concerns about the creditworthiness of the sovereign impact on the bank’s creditworthiness, so ESBies could be a neat way around this problem. Predictably, the German reaction was “Nein, danke”, and a reminder that “Member States must live up to their responsibility to create stability and growth in the Eurozone through structural reforms and debt reduction”. In other words, there’s no chance that Germany will lend its creditworthiness to support the rest of the Eurozone. But maybe it’s not so black and white. These are first proposals, and could be re-worked into something more acceptable. Should Mrs Merkel be re-elected in September, she, along with Macron, will form a strong force for further European integration. Part of that plan might just involve some form of debt mutualisation in return for deeper fiscal integration.
2. Wages and Inflation – Still No Smoking Gun
The familiar theme of strong employment growth but low wage pressure that has been evident in recent years was highlighted yet again last week in both Europe, the UK and the U.S. In Europe, employment and wage data released by Eurostat showed the number of people employed increased by 0.4% in Q1 2017 compared to the previous quarter. Remember that in Q4 2016, employment also increased by 0.4%. In hard numbers, Eurostat estimated that 234.2 million men and women were employed in the EU, the highest level ever recorded. But amidst all this good news was the sobering fact that compensation per employee slowed from 1.4% year-on-year in Q4 2016 to 1.2% in Q1 2017 – well below the 1.7% projected by the ECB staff forecasts for 2017. Energy prices are the largest short-term determinant of inflation, and recent action in the oil price suggests it’s not going anywhere in a hurry. Wages are the biggest long-term determinant of inflation, and the above data shows that wages aren’t going anywhere in a hurry either. It’s the same story in the UK – a significant squeeze on living standards caused by an acceleration in inflation and low wage growth. UK employment rose by a hefty 109k in the three months to April 2017, keeping the unemployment rate at 4.6%, its lowest level since 1975. But average weekly earnings (excluding bonuses) fell from 1.8% in March to 1.7% in April – the 5 th consecutive month of falling wage growth. Probably no surprise then that Visa noted that UK consumers cut their spending for the first time in nearly 4 years last month – “with rising prices and stalling wage growth, more of us are starting to feel the squeeze” said Visa’s Managing Director Kevin Jenkins. And finally in the U.S., not only was annual CPI lower than expected at 1.9% (vs expected 2%); the core rate fell from 1.9% to 1.7%. The Fed decided to look through these soft inflation numbers, and increased rates by 0.25% last week. The ECB have been quite vocal about the difference between strong growth and low inflation, and reminding us that they are more focused on inflation. Which leads us to the Bank of England…
3. Bank of England – The Dog that Nearly Barked
One market commentator described it as “probably the most extraordinary Monetary Policy Committee (MPC) vote I have seen in 17 years”. We’re not sure we’d go that far, but the UK MPC vote of 5-3 to leave the Bank Rate unchanged at 0.25% did surprise pretty much everyone. Kristen Forbes, who retires from the MPC at the end of June, has consistently voted for a rate hike, so no surprise there. But the defection of Ian McCafferty and Michael Saunders to the hawkish camp was unexpected. Three arguments were advanced for “a moderate monetary tightening” – higher-than-expected inflation, diminished slack in the labour market and growth in investment and exports offsetting weaker consumption. But the funny thing is, each of those arguments can be refuted quite easily. Most of the inflation overshoot has been caused by the depreciation of Sterling since the Brexit referendum result, making imported goods more expensive in the UK. In terms of the labour market, our eye was caught by the line in the minutes that noted “however, it was striking that wage growth had remained so weak relative to historical norms”. And as we explain above, in real terms the UK worker is suffering a pay cut, which is hardly conducive to an acceleration in inflation. Finally, the MPC also answered their own concerns about growth by noting that “a slowdown in household consumption, and GDP as a whole, had recently begun, and it was too early to judge with confidence how large and persistent it would prove to be…a period of slower than expected growth could see a margin of slack re-opening”. The composition of the MPC is also likely to work against any rate increase as well – the replacement for Deputy Governor Charlotte Hogg would be expected to vote in line with the Governor, and Kristen Forbes replacement could well be a dove. Lastly, the political uncertainty, coupled with Brexit noise and recent weak economic data, mean this vote was, to paraphrase the Sherlock Holmes author Arthur Conan Doyle, a case of the dog that nearly barked.
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