Markets & Economy
2017 Outlook: European DebtJanuary 19, 2017
- We expect European bond markets will continue to be heavily influenced by technical factors in 2017. Growth and inflation are likely to remain muted, leaving the markets particularly sensitive to monetary policy decisions and political developments.
- The extension of the European Central Bank's corporate sector purchase program should continue to impact valuations by keeping sovereign yields low and compressing spreads, limiting the opportunity set.
- However, a series of parliamentary elections in European Union member states against a backdrop of growing anti-establishment forces could bring further volatility, and spikes in yields, during the year.
- The flexibility to respond quickly to extreme market moves will be key in this environment, but even more important will be the continued focus on fundamentals and security selection.
We expect European bond markets will continue to be heavily influenced by technical factors in 2017. Growth and inflation both are likely to remain muted, leaving the markets particularly sensitive to monetary policy decisions and political developments.
In December, the European Central Bank (ECB) announced that its corporate sector purchase program (CSPP), which was due to end in March, will be extended until December 2017. This should continue to impact valuations by keeping sovereign yields low and compressing spreads, limiting the attractiveness of the opportunity set. However, a series of upcoming general elections in European Union (EU) member states, set against a backdrop of growing anti-establishment forces, could bring further volatility and yield spikes this year.
THE END OF CSPP STILL LOOMS
The extension of the CSPP was expected; the only question was whether or not it would be tapered. ECB President Mario Draghi argued that the ECB’s decision to slow the pace of monthly purchases from €80bn to €60bn did not amount to tapering, and he insisted that tapering had not “even been on the table.” However, market reaction suggested that not all investors were convinced by this: Yields spiked briefly before settling back down again.
Whether the program is being tapered or not, it is clear that the marginal benefit of CSPP is falling and that it will have to end at some point. Speculation about the precise longevity of the program will likely intensify toward the end of 2017, potentially sending yields higher again.
In November, the European Commission downgraded its forecast for EU growth in 2017 to 1.6%—0.3 percentage points lower than it had predicted earlier in the year. The commission said that economic risks in Europe had “clearly tilted to the downside,” and claimed that the UK’s vote to leave the EU had “raised uncertainty and can be seen as an indicator of heightened policy risks in the current environment.” It also warned of political uncertainty arising from a “new backlash against globalization.”
WILL TRUMP’S VICTORY STRENGTHEN EUROPEAN POPULISM?
The true extent of the backlash against globalization will be tested this year in parliamentary elections in the Netherlands, France, and Germany. The main populist parties—Netherlands’ Freedom Party, France’s National Front, and Germany’s Alternative for Germany—are all polling strongly ahead of these elections, and while none are expected at present to win, strong performances by them will create uncertainty and turbulence and may cause yields to spike if investors become spooked. The prospect of the UK triggering Article 50 (stating its formal intention to leave the EU) and Catalonia’s plan to hold a referendum on independence from Spain—with or without Spain’s permission—may cause further volatility.
Populists in Europe will no doubt have been encouraged by Donald Trump’s victory in the U.S. presidential race. European sovereigns sold off following the U.S. election amid anticipation that Trump’s plans to cut taxes and boost infrastructure spending will lead to higher U.S. inflation and interest rates. However, given that it will take a few years to implement major new infrastructure projects, any inflationary pressures they create are unlikely to be felt this year, although the anticipation of stronger growth may exert some upward pressure on yields. Additionally, if Trump moves ahead with his protectionist trade measures, it could dampen growth around the globe, including in Europe.
CREDIT FUNDAMENTALS REMAIN MIXED
The overall picture for Europe in 2017 is one of continued low yields against a background of significant policy and political risks (Figure 1). Credit fundamentals remain mixed. While corporate leverage is on a slowly rising trend in Europe, interest coverage remains very healthy as a result of low funding costs. Moreover, companies in Europe remain very mindful of the last financial crisis and are wary of something similar recurring. This caution has persuaded many firms to focus on maintaining balance sheet strength.
As of September 30, 2016
Past performance cannot guarantee future results.
Sources: Bloomberg Finance, L.P., Bloomberg Barclays Euro Aggregate Corporate Index, and Bloomberg Index Services Ltd.
We expect the performance of European credit strategies in 2017 to be heavily influenced by the interplay between domestic and external political developments. If anti-establishment parties are seen threatening the status quo in national elections, or if European growth comes in lower than expected, this will likely lead to increased volatility, weak equity market performance, and spread widening. At the same time, however, the extension of the CSPP is likely to act as a cushion against spread widening.
The CSPP has also led to divergence in performance among bonds, depending on their eligibility for ECB purchase. This should continue to create relative value opportunities next year, including in the European banking sector, which is not part of the program. For banks, rising and steepening government yield curves should alleviate some earnings pressure, and valuations appear attractive, but we expect bank issues to continue to be strongly influenced by political risk. Periods of weakness and volatility may present good buying opportunities.
CONTINUED UNCERTAINTY ARGUES FOR CAUTION
Continued uncertainty over how the various political and policy developments of 2017 will affect European debt markets necessitates a cautious investment approach. The extension of the CSPP should help to contain spread widening in the short term, but the inevitability of the program being tapered at some point—combined with the beginning of the European "election supercycle" in March—means that risks will be embedded throughout the year. The flexibility to respond quickly to extreme market moves will be key in this environment, but even more important will be the continued focus on fundamentals and security selection. In our view, the coming year likely will be a difficult investment environment, but it should also create interesting opportunities.
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The views contained herein are as of January 2017 and may have changed since that time.
Past performance cannot guarantee future results.
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