3 Things the European Investment Grade Fixed Income Team Talked About Last Week
1. Euro-area Unemployment – Smoke & Mirrors
One of the pleasing signs of the Euro-area’s recovery in recent years has been the drop in the level of unemployment. Having peaked in March 2013 at a level of 12.1%, the unemployment rate has steadily fallen to its current level of 9.5%. But of course, that number hides some large differences from country to country. Spain, for instance, still has an unemployment rate of just below 19%, even if this is down from its highs of 26.9% in March 2013. The Italian unemployment rate never reached such high levels, peaking at 13% in November 2014, but it hasn’t fallen as much either, currently sitting at 11.7%. However, a recent ECB study took some of the gloss off the improvement in unemployment by suggesting that the Eurozone’s labour market is in much worse shape than the official figures suggest. Contained within the ECB’s Economic bulletin, the study noted that despite significant increases in employment, Euro-area wage growth remains subdued. It suggests that there may still be a high degree of labour market slack over and above the level suggested by the unemployment rate. The Euro-area headline unemployment rate is based on the International Labour Organisation’s definition of unemployment. A job seeker is considered unemployed if they are (1) without work; (2) available to start work within two weeks and (3) actively seeking work. But as many of us know, there are at least two categories of people: those who do not meet the last two criteria, or people who work part-time but would like to work more hours. The study suggests that about 3.5% of the Euro-area working population fall into the first category, and another 3% of the population who would like to work longer. Taking other factors into account, the study suggests that labour market slack currently affects around 18% of the Euro-area extended labour force. On this evidence, it’s not surprising that we haven’t seen any recovery in wage growth in Europe.
2. UK Inflation Report – Much Ado about Nothing
It was another “Super Thursday” in the UK last week, as the combination of a Bank of England (BoE) Monetary Policy Committee (MPC) meeting, details of the minutes and the Quarterly Inflation Report combined to catch investors’ attention. What we got was a slightly hawkish shift from the MPC, and a tightrope-balancing act from BoE Governor Mark Carney on the potential effects of Brexit. The voter split was 7-1 in favour of unchanged monetary policy, with retiring MPC member Kirsten Forbes continuing to vote for a rate increase. Prior to the meeting, there had been speculation that Michael Saunders (the newest member of the MPC) might join Forbes in dissenting, but that didn’t materialise. The Inflation Report slightly downgraded GDP estimates for 2017, but slightly increased them for 2018 and 2019. Inflation is expected to remain above target for the forecast period, hitting 2.7% in Q2 2017 and 2.6% in Q2 2018 from its current level of 2.3%. The most interesting line was when the MPC introduced a minor tightening bias by saying “if the economy followed a path broadly consistent with the May central projection, then monetary policy could need to be tightened by a somewhat greater extent over the forecast period than the very gently rising path implied by the market yield curve underlying the May projections”. But, and this was perhaps the most controversial part, this was predicated on the assumption of a “smooth” Brexit. Of course, Governor Carney and the BoE have no better idea than we do of how those negotiations may play out. UK Gilt yields were relatively unchanged after the announcement and press conference – we still think that they offer little value either outright or compared to other markets like the U.S., and if the BoE’s forecasts are right, then yields will have to move higher. Therefore, we maintain our underweight position in UK Gilts. Sterling has weakened a bit, probably based on the expectation that there would be two dissenters on unchanged monetary policy. We are relatively agnostic on the level and future direction of Sterling – we generally feel that it should be lower, given all the uncertainty the UK faces, but most investors are already short anyway so there may be little pressure to push it lower.
3. Falling VIX
The fall in the S&P500 volatility index (known as the VIX) to a 23-year low last week garnered much attention. And whilst most of the attention focussed on the VIX, a similar pattern can be observed in fixed income, credit and FX volatilities – all are either at, or close to multi-year lows. The reasons for such falls are numerous and varied – a reduction in geo-political risk now that the French elections are past, a decent earnings season in U.S. equities, even the swing from actively managed products to passively managed products. The sheer size of global central banks’ bond-buying programmes and the fact that central banks have been so cautious in reducing their Quantitative Easing operations is probably another major reason. The reason that investors worry about such low levels of volatility is that it is seen as an indicator of market complacency – there’s a feeling that volatility should mean reverting and that it should surge higher soon. In fairness, there is some validity to this point. Since 1990, there have been less than 10 days when the VIX dropped below 10. So some rebound might well be expected. But that doesn’t necessarily mean that asset prices are at immediate risk. In 1993 and 2006 (the other two periods when the VIX also hit or dropped below 10), stocks continued to rise for another 2-3 months afterwards, and the level of peak-trough drawdowns were limited to a modest market correction. Interesting though, the U.S. Dollar Index fell in both periods. With political upsets unlikely over the summer, central banks remaining reluctant to end their extremely accommodative monetary policy measures, inflation numbers disappointing in the short-term, and equity earnings meeting expectations, investors may be in for a low-volatility summer.
Source: Bloomberg, Pioneer Investments. Data as of 15 May 2017.
