BlueBay AM: Notes from a region of depressed expectations

Feb 15, 2019

By Mark Dowding, co-Head of Developed Markets at BlueBay Asset Management

Robust US data saw Treasury yields move higher over the past week, with risk assets continuing to rally as growth slowdown worries fade into the background.

A record-high level in job openings and evidence of rising wages pushing inflation higher, reaffirming our view which continues to look for robust US growth and higher rates in the second half of 2019 – in contrast to market expectations, which still expect the next Federal Reserve (Fed) move to be a cut as we move into 2020.

German data signals state of eurozone health

By way of contrast, the outlook in the eurozone looks profoundly different, as evidenced in German growth data at 0.0% quarter-on-quarter in Q4 – only barely avoiding a move into recession with a second successive quarterly contraction.

German year-over-year growth rates stand at a paltry 0.6%, and although some factors are country-specific to Germany, there is a sense of stagnation across the eurozone at the current time and this was a theme echoed in meetings with policymakers in Brussels during the past week.

It seems that across Europe we are living in a land of depressed expectations and while there is hope that economic activity will bounce in H1 following a soft end to 2018, there is a clear acknowledgement that risks to this view lie on the downside.

From a policy perspective, we expect an announcement on a TLTRO replacement from the ECB in the next few months. However, based on official comments, it seems that this may not occur as early as March, as many investors would currently like to see.

We would note that with EUR800bn TLTROs maturing in mid-2020, and further measures that negatively impact bank profitability having been announced since the last time the TLTRO was undertaken, a size of EUR1 trillion would be needed just to maintain the status quo.

It isn’t clear that this is fully appreciated in policy circles at the current time. Moreover, although it seems that a technical measure such as this will help to support economic activity to an extent, it won’t be a panacea should further downside risks buffet the eurozone in the months ahead.

Frustration in Brussels

Elsewhere hopes for a larger, coordinated EU fiscal easing seem to fall on deaf (German) ears. A modest easing in the net fiscal stance is expected in the eurozone this year, versus last year.

However, recent downward revisions to eurozone growth forecasts by the EU Commission seem to have had the effect of causing German lawyers – who control the Finance Ministry – to cut spending rather than increase it counter-cyclically.

There is frustration in Brussels at this German position, and talk that fiscal rules could be changed to fine countries with excessive surpluses – just as they currently target those with excessive deficits.

However, this is a long way off and with a new set of law makers in the European Parliament taking seats in June and a new commission to be installed in October, there is a sense that Brussels is in ‘lame duck’ session and no new policy initiatives are really likely until 2020, absent a much bigger crisis to drive change.

Brexit – from bad to worse…

With respect to Brexit, there were no real developments during the past week. Policymakers in Brussels confirmed that recent Theresa May visits are a total waste of time and more of a charade that she is playing to appease her domestic audience.

It seems highly likely that the fate of Brexit will only be decided in the second half of March and it is expected that this will result in an extension until the end of June.

Ultimately, Brussels expects a deal to get done along Norway lines, but finds it incredibly ironic that this outcome will have delivered the exact opposite of the Brexiteers aims and objectives.

Are we heading back to square one?

Instead of taking back control, Westminster will have ceded all authority to Brussels and won’t have a voice in an entity that will be more dominated by the preferences of Southern Europeans following the UK’s departure.

It is thought that the UK will be trapped in transition for at least 5–10 years, as the next stage of negotiations post-Brexit will be much more complex than the current debate.

During this period, the UK will remain part of the single market, there will be full mobility of labour and in many respects, Brexit will actually look to many as if it is just a ‘fake Brexit’ in name only. This could see a rise of a more populist extreme, but this remains more distant for now.

The principal risk to this benign view coming from Brussels is the accidental hard Brexit, which nobody wants.

Extension looking unlikely

It was noted that for an Article 50 extension, this needs the agreement of all EU member states. Any country has a veto and with Spain possibly set to go to the polls, following the failure of its budget, this could make talks on Gibraltar a Spanish demand for granting an extension – something many Tories could see as unpalatable. Any extension would be on the terms that were right for the EU, not drafted to suit the UK.

This makes an extension beyond 30 June unlikely as there is a fear that if there are no UK MEPs in a new European Parliament, then anything passed by the body would lack legitimacy and be subject to legal challenge.

In this sense, there is no guarantee that Westminster will manage to agree anything by this date and so a ‘no deal’ outcome remains a live possibility – especially in the absence of a sense of crisis.

Should a hard Brexit occur, the EU feels confident that it is better prepared than the UK is, and it is noted that in such a case, the failure of the UK to implement a border with non-zero tariffs in Northern Ireland would see the UK labelled as a smuggler and subject to EU sanctions and WTO proceedings.

Frankly speaking, Brexit continues to look like an unholy mess and it remains appropriate to take a short stance on UK assets and the pound on the assumption that stress levels will need to increase.

New-year pig provides a pick-up

Elsewhere in financial markets, trading following the Chinese new year has been somewhat constructive. The 70th anniversary of the PRC is seen as another reason for Xi to deliver stimulus and support growth in the Year of the Pig, and we can see some evidence that trends in data are slowly turning.

Spanish surprise for corporate bonds

In corporate bonds, Santander’s decision not to call its AT1 bond generated a lot of newsflow, but it strikes us that the main parties upset by this are syndicate desks, which may be much less busy if many other banks follow suit over time.

It has been curious that European investors don’t seem to understand the principle of an ‘economic call’ when this has been the way US markets have functioned in MBS and elsewhere for many, many years. Ultimately, we see this only benefitting active managers with the right analysis and skill sets.

Trade talks could provide a lift

The next couple of weeks could see a focus on trade. We remain hopeful of a constructive resolution to China / US talks, as described previously, as we think that Trump wants a ‘win’.

We are more concerned that we could be approaching negative news on 232 auto tariffs, which will principally impact the EU, and Germany in particular.

There may be a sense of justification in this move, in that Germany persistently runs large current account surpluses and should be singled out as a country that needs to change. It seems that the German economic model is rooted in the past and Berlin must wake up and change.

In this context, a blast from Washington may not be bad for Europe in the end, but in the near term, this may only add to woes in the land of depressed expectations.

Mind you…in the midst of this sober-sounding talk, at least the lame ducks in the EU are still afloat. This is not something the UK can even manage, after confessing it is having to scrap a project to run ferries to deliver food to Britain in the event of a hard Brexit, on boats that don’t even exist, to a port in Ramsgate which couldn’t even have handled them. In that context – better a lame duck than a dead one.