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The Eurozone: QE Returns

By Luke Hickmore, Senior Investment Manager, Fixed Income - EMEA

The long-term success (or otherwise) of the Eurozone’s first go at quantitative easing is still up for debate. Nevertheless, it was an instant hit in some quarters and now hints from Mario Draghi, president of the European Central Bank (ECB) have its fans clamouring for more.

Why does the Eurozone need a sequel?

In the decade since recovery from the global financial crisis, the Eurozone’s economy has grown at only a very slow pace, peaking at a year-on-year rate of 2.8% in the first quarter of 2011 and the fourth quarter of 2017. Figures for the first three months of 2019 show expansion of just 1.2% and more recent data are pointing at a sharper slowdown to come. Inflation in the region has also been determinedly sluggish. Couple these with faltering German industrial production and the bloc’s position in the middle of the US-China trade dispute and it’s easy to see why the ECB recently downgraded its growth and inflation expectations to levels that highlight the need for more stimulus. It now expects growth of 1.4% next year, above our expectations of 1.1%. Its inflation predictions for 2020 and 2021 are 1.4% and 1.6% respectively. Again, based on the amount of spare capacity in the Eurozone economy, we think these forecasts are too high.

In June, the ECB stopped short of a rate cut, but Draghi stated that “additional stimulus will be required” if economic performance continues in the same vein. Since his speech in Sintra, Portugal, markets have moved quickly to price in a sharp slowdown in inflation. An important gauge of inflation expectations, the five-year forward five-year German inflation swap at 1.2% is now well below the central bank’s forecast of 1.6% in 2021.

In the past, such low expectations have triggered asset purchases from the ECB. Since the ECB needs to generate confidence in its ability to reach and maintain inflation at 2%, it’s very likely that, once again, QE will be a key part of its approach to raising inflation expectations.

Which assets will benefit from QEII and its build-up?

Already, government bond yields are collapsing to lower levels. At the time of writing, negative-yielding debt is valued at $15.2 trillion globally. This trend is likely to continue and, with the ECB forecast to cut the deposit rate once again, a move towards -0.5% for 10-year bunds cannot be ruled out. Investors’ search for yield, therefore, is leading them increasingly to longer-dated corporate bonds in Europe and further afield.

This should continue to support European credit, which has performed well over the first half of 2019. I expect it to continue to do so, supported by strong returns from government debt and a narrowing spread. This dynamic is also likely to lift UK credit – European issuers make up just over 20% of the UK market. As the yield hunt intensifies, subordinated financial and non-financial hybrid bonds could also do well.

This time, it’s different…

There are also likely to be some subtle differences from QE’s first European outing. The ECB might adjust its self-imposed maximum limit on how much it can purchase from each government. If it does, it might choose to make 50% of the total purchases from the German market. And because it will be keen to avoid political fallout from buying too many bonds from countries such as Italy, corporate bonds could get a much higher billing this time around. It still seems unlikely that the ECB will buy financial bonds, though. After all, as the industry’s regulator, questions would be asked if it appeared to be buying one bank and not another.

Is it relevant to a Brexit-era UK audience?

Globally, the links between credit markets are strengthening. Gaps in relative value between the sterling, euro and dollar bonds of any one issuer can be absent for extended periods. With the ECB likely to be buying corporate bonds in secondary and primary markets from the end of this year, any difference in relative values between euro and sterling bonds from the same issuer is unlikely to exist for long.

The search for yield continues

While European corporate bonds have their attractions, it’s important that UK investors don’t forget what is driving the need for this second instalment of quantitative easing in the Eurozone. The region’s troubles also put a spotlight on slowing UK growth and the increasing risk of recession. It is not an environment in which credit would typically thrive. We are looking to add to funds companies that have proven track records of coping well in downturns. Good asset quality and good governance are among the best indicators of star quality.

A version of this article was published on ftadviser.com on 7 August 2019.

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