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

Big wave over old lighthouse

1. Brexit – Theresa May seeks BAFTA for La La Land performance 

In last week’s blog, we highlighted an important speech to be given by UK Prime Minister Theresa May on her vision for how the UK would manage Brexit and life after membership of the European Union. On the positive side, her speech (delivered on Tuesday January 17th in London) appeared to be quite clear about certain things that had been sources of concern up to now. The UK will be leaving the single market, Parliament will be given the final say on any potential deal negotiated, and there was an acceptance that a transitional agreement might be necessary at the end of the two-year negotiating period. This week, the UK Supreme Court is widely anticipated to rule in favour of the Parliament voting on whatever deal is negotiated with Brussels, but PM May gave no clues as to what would happen if the Parliament were to vote against her deal. On the negative side, however, there were still some signs that PM May and her team have unrealistic expectations for what they could achieve in their negotiations with Europe. For instance, her speech noted that “the days of Britain making vast contributions to the European Union every year will end”. But we also know that the EU have been very explicit in stating that the UK would still be on the hook for projects already started or running, and that there could be a significant financial cost to leaving the EU. This is likely to be a key battle between both sides in the negotiations. Another line stated that May “does not want to be part of the common commercial policy…but I do want us to have a customs agreement with the EU”. Unfortunately, in Europe, this is seen as having your cake and eating it – a kind of “a la carte” selection of the things that the UK likes, but simultaneously rejecting the things they do not like. The most stark and forthright part of May’s speech was as follows: “What I am proposing cannot mean membership of the single market…we do not seek membership of the single market. Instead we seek the greatest possible access to it through a new, comprehensive, Bold and Ambitious Free Trade Agreement” (hence the acronym BAFTA). This is Ground Zero Hard Brexit. Finally, there was the comment that noted “I want us to have reached an agreement about our future partnership by the time the two-year Article 50 process has concluded”. So still believing that a full and complete BAFTA could be completed in two years – there are plenty of people who believe this timeline is simply too ambitious. Although Sterling rallied after the speech, we still believe that UK assets could struggle once the talks actually begin. We continue to believe that an underweight stance in UK government bonds is warranted.

2. ECB Meeting – “Nothing to See Here, Move Along Please”

As we anticipated, last week’s ECB meeting and subsequent press conference was one for the ECB-watchers, and even they struggled to find anything new or interesting to write about. We even spotted one journalist struggling to stay awake, which must be a first for an ECB press conference. All current monetary policy settings were left unchanged, with the message continuing to be that the ECB “stands ready to increase the programme in size and/or duration…if the outlook becomes less favourable”. The key message from President Mario Draghi and the Governing Council was that they acknowledge that headline inflation will pick up in coming months (due to base effects, which we have mentioned many times previously in this blog). However, the ECB have decided to look through this rise in inflation, which is driven by the oil price increase compared to this time last year, because “there are no signs yet of a convincing uptrend in underlying inflation”. In our projections, we believe that it is quite possible that headline Euro-area inflation could peak around 1.7%-1.8% around April 2017, before falling away again. But those same projections see very little upward progress in core inflation – certainly not much higher than 1.1% or so. Mr. Draghi did outline four criteria that the ECB will be seeking to consider that a “sustained inflation adjustment” has occurred:

  1. Inflation converging to the ECB’s medium-term target of “close to, but below 2%
  2. Convergence must be sustainable
  3. Convergence must be sustained without monetary policy support
  4. Convergence must be across the whole of the Eurozone.

The last comment was a direct riposte at Germany, where inflation has risen to 1.7% and has led to calls for a tightening of monetary policy. Draghi did seem to suggest that a stronger Eurozone economy should eventually benefit everybody, even German savers and pensioners. So the message was to remain patient, that monetary policy works with lags but that things are getting better, and that everyone will benefit eventually.

3. European Political Risk

At this stage, most investors are aware that 2017 may well be a year of significant political risk in Europe. National elections are scheduled in France, Holland and Germany, with an outside possibility of elections also being held in Italy and perhaps the UK. Of course, given the three electoral results in 2016 in the UK, the U.S. and Italy, investors are rightfully keeping a wary eye on developments in these countries. Over the weekend, we received the first set of results in the French Socialist Party primary contest to select their candidate for the national elections, the first round of which will be held on 23 April 2017. The ex-French Prime Minister, Manuel Valls came in second place, polling 31.5% and trailing the little-known Benoit Hamon, who garnered 36% of the vote. A former industry minister, Arnaud Montebourg, was quite a distance behind with 19%. Mr Valls was once a rising star of the Socialist Party and Sunday’s result was a shock, in the same way that Francois Fillon galloped away with the centre-right Republican nomination. For the Socialists, it appears that their candidate trails, by some distance, Emmanuel Macron who is running as an independent. But the two front-runners remain Mr Fillon and the Front National’s Marine Le Pen, with Mr Fillon widely predicted to emerge victorious from the head-to-head second round of elections on May 7th 2017. Before that, in neighbouring Netherlands, the country will vote in national elections on March 15th. Despite the Eurosceptic PVV party leading the polls, it is believed that the chances of a PVV government are slim, and there are significant obstacles to a Dutch exit from the EU. Last year’s election results taught us to treat polls with a healthy degree of scepticism, but it does look like political risk in Europe may be less than markets are worrying about. If the elections results follow the polls, it might suggest that semi-core and peripheral sovereign bond markets offer value at current spreads. We continue to believe that a long Italy versus short Germany position in the 10-year area of the curve is attractive.