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

1. Euro area – Firing on all Cylinders

Data released last week highlight the extent of the dilemma facing the ECB over the coming months. Purchasing Manager Indices (PMI’s) for the Euro area, and survey data for Germany, both pointed to a region enjoying its strongest growth for quite a while. The Eurozone Composite PMI was stable at a level of 56.8, its highest level in 6 years and slightly higher than the market had expected. This should equate to an annualised level of GDP of 3%, although the actual level of GDP in Q1 2017 didn’t quite match that forecasted by the PMI’s. And the even better news is that the strength is broad-based. German and French PMI’s are at the same level, and although the peripheral PMI’s were slightly lower than previous prints, they are still at levels that indicate healthy expansion. Having lagged for a while, the Manufacturing sector has caught up with the Service sector, mainly due to strong growth in the export segment. The Employment component continues to look good, and whilst input prices were down, output prices stabilised. The German IFO survey for May (released on the same days as the PMI’s) reinforced the message – business sentiment increased to 114.6, a 47-year high, driven both by better current conditions and expectations. Extrapolating from the May number would suggest that German GDP is running at close to 3% in Q2 2017. Like most others, our forecast for Euro area GDP in 2017 is slightly sub-2%, but the risks are now that the number comes in slightly above 2%. Not a massive game-changer, but enough that the ECB could drop their dovish language at their next meeting in Tallinn on 8 June. That’s the easy part – the hard part is what to decide on tapering later in 2017.

2. Oil – Buy the Rumour, Sell the Fact

Last Thursday’s announcement by the Organisation of the Petroleum Exporting Countries (OPEC) of a 9-month extension to its existing production-cut agreement with non-cartel members was no surprise – it had been well flagged in the preceding days. So why did the oil price plummet over 7%? It seems a classic case of “buy the rumour, sell the fact”, given that the oil price had already appreciated from a low around US$46 in early May to US$51.5 just before the OPEC announcement. Despite the fact that the terms, targets and exemptions of the extension were all the same as were agreed in November 2016, the market appears to have been expecting either a longer extension timeframe, deeper production cuts or more producers joining the pact. The agreement is an attempt by the two major players in the world’s oil market, Saudi Arabia and Russia, to rebalance the market after a dramatic 50% fall in oil prices since 2014. That fall has had a knock-on effect on the state budgets of those countries that are dependent on oil for most of their revenues. Nevertheless, the benefits of the agreement (first agreed in November 2016 and implemented in January 2017) have been slow to appear. Oil inventories continued to rise for the first three months of the year, and only recently have any signs of a decline become apparent. In part, this is due to the ability of U.S. shale oil producers to quickly increase supply as prices increase, thus filling some of the gap left by the afore-mentioned production cuts. We’ve mentioned before the close linkage between the oil price and inflation, and the chart below attests to that relationship. However, what’s interesting is that even as the oil price rebounded recently, European inflation expectations didn’t follow suit. The market is sending the ECB a strong message – they don’t believe the ECB will achieve their inflation target. We currently prefer to play the inflation theme through a normalisation of real yields, rather than outright positioning for a recovery in inflation expectations.

3. UK – Three in a Row?

The 2015 UK general election caused a significant upset, returning a Conservative majority when the bookies had a 90% chance of a hung parliament. Then last June, with the bookies being similarly confident on a “Remain” vote (although the polls were closer), the electorate voted to leave the EU. So with recent polls showing a dramatic fall in the conservatives lead, it’s no wonder that people are getting twitchy. When UK Prime Minister Theresa May surprised pretty much everyone by calling an early election, initial polls showed that the Conservatives had a healthy 20-point lead in the polls over the Labour party. Because of the UK’s rather unique “first-past-the-post” electoral system, it’s hard to translate this lead into actual seats, but political experts were suggesting that May’s majority could rise to anywhere between 50 and 100. And against that backdrop, the markets shrugged their shoulders and paid little attention. But Mrs May hasn’t had it her own way in the last two weeks. Firstly, she did a rapid back-track on the so-called “Dementia Tax”, an ill-advised suggestion that people needing care at home would have to fund it themselves until the value of their assets, including their home, fell below GBP£100,000. Secondly, it has become increasingly apparent that the Brexit choice will most likely be between a Hard Brexit and a Really Hard Brexit, as the EU negotiators stick to stated positions. Finally, inflation has picked up at the same time as growth has fallen dramatically. This week, Sterling finally took notice, falling from above 1.30 to just below 1.28 against the U.S. Dollar. Admittedly not much, because the U.S. Dollar has also been weak, but against the Euro the UK currency has fallen from 0.84 in mid-May to 0.8730 last Friday. Recently we’ve been relatively agnostic about Sterling, but have now decided to underweight the currency for the next couple of weeks, in case the depreciation accelerates.