As Europe’s economy continues to recover from COVID-19, it appears the central bank will remain accommodative, but for how long? Our Head of European Fixed Income David Zahn shares his views.
At its meeting on June 10, the European Central Bank (ECB) remained committed to supporting the market, confirming its very accommodative policy stance as the economy continues to recover from the pandemic. Marketwatchers were concerned that the tap might be turned off or reduced, but the ECB signaled it would continue to buy bonds under its €1,850 billion Pandemic Emergency Purchase Program (PEPP) “at least the end of March 2022 and, in any case, until it judges that the coronavirus crisis phase is over.”
Since the beginning of the year the ECB has stepped up the pace of its bond buying to around €80 billion per month over the past quarter and said it would continue to buy at an accelerated rate as conditions warrant.
The ECB also raised both its growth and inflation forecasts for this year. The growth forecast for this year was raised to 4.6%, up from its prior forecast in March of 4%. It also raised its inflation projections to 1.9% this year (just below its 2% target) up from its previous forecast of 1.2%.
The economic forecast has changed quite dramatically and reflects incredible growth for Europe. We are clearly seeing a strong rebound in Europe—but the magnitude of growth is likely to be more temporary in nature, so this could be the last policy meeting where we will see this type of accommodation. That means there will probably be more volatility in the markets over the next couple of quarters as there will be a battle between hawks and doves.
The ECB also said the risks are balanced to the economy, and I think that’s the first time it has used that language in a number of years—the ECB hasn’t generally been this optimistic. That said, I don’t think the central bank wants to make any major change before their strategic review at the end of the summer, where ECB policymakers review the state of economy, inflation and how they think about their inflation target, how they communicate to the public, and the monetary policy tools they have to achieve their goals, among other things.
As growth and inflation pick up, it certainly makes sense to think about removing some accommodation. That doesn’t mean bond yields will rise, but peripheral bond spreads are likely to widen. The reason they have been so tight is because of ECB buying, and if that support is reduced, it’s natural we will see some market shifts.
As such, in the current environment, we are not particularly keen on peripheral bonds but we still like corporate credit—both high yield and investment grade—as they should do well with higher growth and pass through of price increases tied to inflation. While we think yields in Europe will remain low in the short term at least, we remain defensively positioned because we think yields should be higher due to inflation pressures over the longer term.
Inflation: Lower for Longer in Europe?
Inflation is more of an issue in the United States than in Europe. Mainland Europe’s vaccination rates are still much lower than in the United States, and that has certainly had an impact on people’s mindset and their spending habits. We aren’t seeing the same degree of pent-up demand and inflationary pressures in Europe.
In general, Europe doesn’t generate domestic inflation, it imports it. Even Lagarde has said they haven’t seen the same dynamics in Europe; labor markets aren’t as tight as in the United States. Although some commodity prices are going up, like lumber, for example, it’s marginal. Producers are seeing prices going up in the United States, so they are shipping more goods there. Everything else being equal, inflation in Europe is likely to remain lower than in the United States due to structural issues.
European gross domestic product experienced a big drawdown last year and is coming back quickly. That is certainly encouraging because it took a decade for growth to return to the same level after the global financial crisis. So, this is quite positive for investors in Europe. But once you look past this year and next, we are probably looking at a return to growth rates of around 1.5% or 2%, absent a fundamental shift. However, there are attempts to drive higher rates of growth longer term through innovation, digitalization and the greening of the economy. I would also note that money has not yet been disbursed from the European Union (EU) rescue package; that probably will happen in the third quarter and we should see some impacts in the economy in terms of spending and inflation.
Politics in Europe
As investors, we have to keep an eye on what’s happening politically, and the key event coming up is the German election in September. It will be interesting to see how the Green party fares. It looks like the Green party will be part of the government to some degree, which probably means expanded spending, which would be good overall for growth.
Next year, the French election will be a big focal point in Europe. Marine Le Pen and her far-right party appear likely to get through to the second round and people will start questioning if she will win.
Germany has discussed whether individual countries in the EU should have veto rights in foreign policy, and that has upset some countries in the bloc that like to use the veto to maintain control. It appears that Europe is starting to develop more into a majority instead of unanimous consensus, which could foster more efficient governance. That said, not all countries ae happy about that—for example, there has been talk of a Dutch “Nexit.” It just shows the bloc is not homogenous.
The United Kingdom and Lingering Brexit Issues
Meanwhile, the United Kingdom is bouncing back even more quickly from COVID-19 than mainland Europe. There are lingering trade issues tied to Brexit; for example, the EU is talking about a “sausage war” with the United Kingdom, because the United Kingdom made sausages that weren’t allowed to be exported to Europe. It had an amnesty to Northern Ireland until June, but the EU is saying that has to stop. UK Prime Minister Boris Johnson is looking to renegotiate the northern accord, but the EU is sticking to it.
It’s just another in the list of trade disputes—earlier in the year it was fish. These industries are relatively small in terms of the economy. But, trade deals are being done between the United Kingdom and the rest of the world. I think the UK economy will continue do well, but that’s mainly because the government has provided a lot of COVID-19 relief. We’ll probably be talking about Brexit for years to come and ongoing arguments between the United Kingdom and Europe.
In sum, the market does need to factor the end to COVID-19 support at some point, whether in the United Kingdom, Europe or elsewhere. Given rising growth and inflation trends globally, it would be hard to justify continued central bank accommodation at such high levels. The big bond buyer will disappear—and while the ECB isn’t likely to sell, who replaces that buyer? There will still be big issuance from the governments, so I would anticipate some pressure on yields to rise in the next six to 12 months.
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