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

1. UK & Article 50 – “It’s the End of the World as We Know It” 

Last week, following a bit of back-and-forth between the lower House of Commons and upper House of Lords, legislation was introduced that allows UK Prime Minister Theresa May to trigger Article 50, and thus start the long-awaited process of the UK’s disengagement from the EU. The House of Commons rejected some House of Lords amendments, which had included guaranteed rights for EU citizens in the UK, and an amendment allowing Parliament a ‘meaningful vote’ on May’s negotiation terms with the EU. At the time of writing, the exact date of triggering Article 50 is unknown, but it is unlikely to be before EU celebrations to mark the 60th anniversary of the EU’s founding treaty on March 25th in Rome and the Scottish National Party conference last weekend. The UK parliament goes into recess on March 31st, which would suggest that the period March 27th-30th could be the most likely trigger dates. As if that’s not enough excitement, Scotland’s First Minister Nicola Sturgeon called for a second Scottish independence referendum before the UK leaves the EU. On top of that, nationalist politicians in Northern Ireland are calling for a referendum on a United Ireland to be held “as soon as possible”. The possibility of the end of the United Kingdom is growing larger by the week. Meanwhile the prospect of another Scottish referendum adds to the complexity of UK Prime Minister May’s task – as one commentator noted, “it’s hard to negotiate a trade deal when you don’t know what territories you’re negotiating on behalf of”. Given the electoral timeline in Europe (with a new German government not likely to be in place before end-2017), it’s difficult to see how any real progress will be made in negotiations until then.

2. Dutch Elections – Much Ado about Nothing

We talked in last week’s blog about the possible results of the Dutch election and their possible effects on the European political landscape. In the end, it turned out to be a somewhat of a damp squib. The incumbent Prime Minister Mark Rutte’s VVD party won 33 seats out of a total of 150, leaving him in pole position to form a coalition government. But at least four parties will probably be necessary to make up that coalition, suggesting that complex negotiations lie ahead, that may stretch into months rather than weeks. So what are the key takeaways from the Dutch election result? Firstly, everything is relative. Rutte’s VVD party lost 8 seats, but was still proclaimed as the big winner. This is because pre-election polls showed the VVD party winning between 24 and 28 seats. It’s not often you can lose 20% of your parliamentary seats and still call yourself a winner. Secondly, the turnout last Wednesday rose from 74.6% in 2012 to 81%. Typically, anti-establishment parties do better when the turnout is low. There’s a message there for French politicians. Thirdly, the pro-European parties made substantial gains. Both the GreenLeft and D66 parties ran openly pro-European campaigns and ultimately benefitted in the results – D66 captured 19 seats putting them in third place and GreenLeft quadrupled their seats from 4 to 16. The reward is that at least one (and possibly both) of these parties will be in the next coalition government. Finally, the result raises the question as to whether we have seen the peak in populism/Euroscepticism? If so, it should sooth investors’ concerns about the possibility of France Marine Le Pen winning the second round of the French elections on 7th May. What may be happening is that the populist/anti-EU parties are influencing the political debate by their presence and manifestos, but the electorate are unwilling to make that final big leap to voting for these parties. This would back up our view that political risk in Europe is over-estimated in the bond markets, and should provide support for our view of higher core European bond yields.

3. Our view on Currency markets

Currency markets have been relatively well behaved since the start of the year, keeping within recent ranges. But that doesn’t mean there haven’t been opportunities to make (and lose) money. The market has been characterised by large uncertainty but low volatility. Low- probability but high-impact events have been worrying markets (Brexit, Trump’s fiscal stimulus, European elections), but these have been difficult to trade as the risk/reward profile is unattractive. For instance, financial market participants have been worried about a Le Pen victory in the French elections, given her anti-EU stance, but can you really position for a Euro break-up? We also feel that many themes are probably close to being fully played out by now – Sterling has already seen a significant depreciation on Brexit fears, the Mexican Peso has largely priced in the effects of a Trump administration, whilst the Turkish Lira has weakened significantly on political concerns. At current levels, we see having exposure to the Euro and the U.S. Dollar as favourable. The Euro should look attractive as soon as political risk starts to diminish (arguably already happening following the Dutch election result), and because the ECB may come under pressure to accelerate the tapering of their bond-buying programme. This should put upward pressure on core Euro-area bond yields, which in turn should give some support to the Euro. Likewise, the U.S. Dollar should benefit from increased expectations of higher U.S. short-term interest rates and bond yields. We suggest that investors consider avoiding the Japanese Yen, and even though most of the major depreciation in Sterling is probably behind us, we still believe that a short Sterling stance is warranted. With political concerns still looming in both countries, we think it is prudent to avoid the South African Rand and Turkish Lira, so we believe that a short stance in both is also warranted. Overall, our favourite currency is the New Zealand, especially against the U.S. Dollar, Canadian Dollar and the Australian Dollar. We expect stronger economic data in New Zealand will put pressure on the Reserve Bank of New Zealand to consider moving to a tighter monetary policy stance, thus supporting the New Zealand Dollar. Overall, we don’t see any significant trends in currency markets at the moment, and so we advocate having a larger number of small trades, and looking more at relative value opportunities rather than trending markets.