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Why we’re underweight European bonds

Kris Xippolitos

By Kris Xippolitos

Head - Fixed Income Strategy

September 11, 2018Posted InInvestments, Fixed Income and Investment Strategy

Since the ECB announced in June their intention to end QE in 2019, core long-term rates in the EZ have moved lower. Though somewhat counter-intuitive, there are a number of factors dissuading investors from discounting the likely increase in net government supply. We will touch on a few, however, we expect markets to eventually price in the end of QE, pushing long-term rates higher. Considering 30% of the EZ sovereign bond market still trades with negative yields, and 7-10 year maturities average less than 1%, we remain underweight. In our view, even the slightest increase in yield will have a significant negative impact on euro fixed income performance.

 

On the macro front, recent economic data has been encouraging. Eurozone PMI’s continue to signal expansion, despite falling from much higher levels. 2Q real GDP growth of 0.4% (2.2% year-over-year) beat market consensus, and Citi economists remain confident that growth will exceed expectations. Unemployment also continues to fall, with the latest Eurostat reading hitting 8.2%, its lowest since 2009. However, core inflation remains below the ECB’s mandate. With the advanced reading for August core CPI showing a decline to 1.0%, the ECB’s need to provide relatively accommodative policy becomes reaffirmed.

 

As announced in June, the ECB is expected to taper monthly bond purchases in October, then cease expanding balance sheet in January 2019. However, ongoing central bank purchases continue to provide meaningful technical support. Excluding France, net government bond supply for the Eurozone (after ECB purchases) is expected to remain negative this year. This will likely change in 2019, pressing euro rates higher. However, the ECB will be reinvesting maturing assets for an extended period beyond the end of QE. In our view, reinvestment can still play a role in keeping local yields relatively contained, albeit minor.

 

Trade conflicts between US/China and US/European Union (EU) have also spilled over into European risk assets, driving flight to quality. With the external dependencies between China and Germany significant, trade-related weakness in China data has negatively impacted German equity markets. Indeed, Germany equities has declined 6.5% this year, underperforming the region. Additionally, US threats to place tariffs on all EU car imports has fueled a 15% decline in the European equity auto sector. While US/China trade negotiations will be fluid, we do not expect the US to impose auto tariffs on the EU. That said, upon a US/EU trade deal, it’s likely we could see some relief in core euro rates.

 

Markets also still need to contend with the instability in Italian politics. An EZ referendum is a low probability. However, fiscal and growth concerns are rising. As such, non-domestic investors continue to reduce exposure, pressing spreads (to Bunds) wider. Guidance over deficit targets will be watched closely, with expectations between 1.5-2.0%. This would likely calm bond investors on the issue of debt sustainability. Indeed, Italy’s debt-to-GDP ratio is among the highest in the world at 130%. Markets will also keep a close eye on Moody’s and S&P ratings reviews, expected in October. Downgrades could lead to further outflows and wider spreads. Italy remains our deepest underweight in the EZ.

 

Despite relatively higher yields and wider spreads, we prefer to avoid Italian sovereign markets. Though political leaders seem content on maintaining reasonable deficit-to-GDP targets for 2019, others may still prefer a more confrontational approach. In our view, market confidence will remain critical for Italian bonds. A decline in confidence can further impact spreads, which in turn could negatively impact financial conditions and hamper growth. While recent auction demand was encouraging, potential downgrades by rating agencies can create renewed outflows, creating further pressures on valuations.

 

Investors will likely be focused on whether we see any deal between the EU and UK. Our base-case view is that the two sides reach an agreement (and Gilt yields rise). However, risks of ‘no deal’ are not negligible. If negotiations fall apart, it’s likely that Gilt yields drop sharply, as recession risks rise and rate cuts are priced in. However, the subsequent currency weakness may eventually fuel a rise in inflation, or create outflows from concerned investors. This type of asymmetric outcome leaves us underweight. Of course, we are not alone. Recent Bank of England data shows that foreign investors were net sellers of Gilts by the largest monthly amount since 1982.