14 July 2015 Fixed Income in the Euro Zone The quarterly fixed income newsletter of Allianz Global Investors Editorial To a stronger euro and European Union FRANCK DIXMIER GLOBAL HEAD OF FIXED INCOME From late April into early May, euro zone fixed-income markets suffered their most severe correction since the inception of the euro. It is hard to pinpoint a single cause, as the spike in yields was due to a combination of factors: l overdone valuations that were completely unhinged from fundamentals; l an extreme market positioning; l the growing feeling by investors of the widening divergence between disappointing US economic data and a euro zone economy that just kept producing positive surprises in the first part of the year. In a market environment hit by a severe lack of liquidity, this combination of factors triggered the unwinding of all Quantitative Easing (QE)-related strategies in a sudden bout of volatility. To use a metaphor, the fixed-income markets are now located on the fault line between two tectonic plates facing off against each other, generating severe tremors in the zone of contact. On one side, the massive QE-triggered imbalance between supply and demand of bonds is tending to anchor yields at low levels, while, on the other, euro zone reflation trades reflecting the cyclical upturn and the accompanying return of inflation is steering interest rates upward. In this face-off, fundamentals will probably carry the day over technical flow factors in the medium term. However, it would be a mistake to underestimate QE s influence, particularly in the very short term. Let s not overlook the fact that in July the net supply of euro zone government bonds will be a negative EUR 120bn, and that will offer support to fixed-income markets. Be that as it may, investors are obviously much smarter after this recent phase, and market psychology has shifted radically: no one is expecting a steady decline in yields any longer and, hence, the only reason for investors to buy bonds at negative real yields which they would only do if they expected even lower yields is gone forever. In terms of lessons learnt, we are also convinced that the markets have moved to a different level of volatility. Market positioning is now far more evenly balanced, and this QE vs fair value» face-off is likely to create to significant market shifts, whose effects will be exacerbated by increasing illiquidity. This lack of short-term visibility on the direction of euro zone interest rates is being exacerbated by uncertainty on whether the Greek crisis will evolve. Uncertainties are squeezing spreads and favoring the Bund in a classical flight to quality. But whatever the future developments and despite the woes of the Greek population, the risk of contagion across the Eurozone appears to be relatively limited: the euro area is much stronger now than during the last government bond crisis, and ultimately these events may prove salutary over time and lead to a stronger euro and European Union.
Key macro trends & investment strategy Europe: Greece on the spotlight EU Big 4 Manufacturing PMI The last weeks of June have been dominated by the evolution of the situation in Greece where, in a surprising move, the Greek government has called during the first week end of July, a referendum on the set of measures proposed by the Institutions (i.e. the creditors). After the no win, we believe we are truly in uncharted territory, as it is difficult to predict that a deal could be reached in the coming weeks. With the EUR 3.5bn in debt due on 20 July in danger, the European Central Bank (ECB) could recall the EUR 89bn in Emergency Liquidity Assistance (ELA) already with Greek banks, forcing Greece to start working with a parallel currency. Source: AllianzGI, Bloomberg - June 2015 ECB Balance Sheet (Asset Side) Greece aside, European data continue to show up on the positive side. Composite PMI rose better than forecasts in May for the Eurozone, posting a 54.1 vs. a 53.6 of consensus. This improvement resulted fairly spread between all countries, signaling that the combination of better credit conditions, euro depreciation and ample liquidity have finally started to be transferred into real economy. The improving economic outlook for the Euro Area, and especially for its peripherals members, is also a key ingredient in the expected resilience of the Eurozone to the Greek turbulence. In fact, while Draghi expressed that investors should get used to higher bond market volatility, he also hinted that at some point unwarranted monetary tightening (due to the situation around Greece) could trigger the ECB to add to its non-standard measures. The decision of the ECJ gives the ECB a Eurozone headline and core Inflation 2
high degree of discretion to implement additional measures. Should peripheral yields start to rise more significantly, the ECB could either front-load QE, expand it in size or duration, adjust PSPP modalities in a peripheral friendly way via a deviation from capital keys, or even launch a separate programme, including broader purchases of peripheral assets, like corporate bonds. The ECB balance sheet can easily expand further. As far as inflation is concerned, last figures came within the markets expectations at +0.2% year over year (yoy) after 0.3% in May and 0% month over month (mom). The core inflation inched lower at 0.8% yoy. Again, the energy price component has contributed negatively at -5.1% yoy from the -4.8% last month. The services price inflation went down to 1.0% yoy from 1.3% and mostly explains the decrease in the core measure. The surprise came from Germany: German HICP receded at +0.1yoy vs +0.7% in May, with this slide largely coming from the unwinding effect of the package holidays last month. Although this is only the second month in positive territory, the path of inflation rate is still expected to increase as base effects from last year s drop in crude will vanish and will lead to significant upward pressure on the headline inflation through the third quarter of this year. USA US Citi Economic Surprise Index After a slew of disappointing numbers, finally consumption is recovering in US. May retail sales have bounced, posting a month over month rise of 1.2%, which helped to stabilize forecasts concerning 2Q15 GDP growth. Citi US Surprise index, after a big decline that took it close to former 2012 lows, has started a decent bounce, signaling the fact the readjustment in expectations can now be completed. The Atlanta Fed model on 2Q GDP forecasts, which has been very effective in forecasting Q1 big miss in consensus forecasts, is now predicting a +2.0% 2Q GDP growth rise which is not too far from expectations. May Durable Goods, slightly disappointed, posting a +0.5% in the Ex-Transportation figure, with downward revision of former month, but are anyhow pointing toward a stabilization. In the last meeting, as expected there was no change in the fed fund rate, but the tone was slightly more dovish than expected: 15 out of 17 Federal Open Market Committee (FOMC) participants look for a rate lift-off in 2015, with the median fed fund rate projection for year end 2015 remained unchanged, implying 2 hikes. 4 participants shifted in favor of just one hike by year end, suggesting more policy caution. Atlanta Fed GDP model Source: Blue Chip Economic Indicators and Blue Chip Financial Forecasts 3
The FOMC lowered the growth estimates for 2015 in line with the soft patch in Q1 from 2.5% to just 1.9%, but noted the more upbeat recent data which is consistent with the view that Q1 was indeed largely transitory in the statement. Labor market conditions improved somewhat further over the recent past: in our interpretation, the FED policymakers believe that labor market conditions have come closer to those consistent with the employment mandate. As a consequence, we believe that the possibility of large disappointments in Q215 growth have substantially reduced after that consumption data has bounced and our base case of a September lift off remains unchanged, with a gradual tightening thereafter. Market pricing however continues to be too pessimistic in our view, with first rate hike fully priced in only for March 2016. USD: Dot charts (following the June 2015 FOMC meeting), OIS per July 6th China : GDP Japan and Emerging Markets In Japan, recent macro data continue to disappoint: Industrial Production fell more than expected in May, posting and month over month -2.2% decline and June flash Manufacturing PMI s fell to 49.9, reversing the gains realized from April. The declines was larger than consensus expectations. A high jump in new export orders, combined with the decline in total orders has led to a drop in domestic orders, rising more points concerning the situation of domestic demand. Outlook for the next months remains uncertain. In China, June Flash Manufacturing PMI rose to 49.6, showing an improvement, but anyhow remaining below the 50 level. On the other side, the employment component fell 1.9 points to 46.8, which represent the lowest reading since March 2009. People s Bank of China announced a cut in both the required reserve ratio and benchmark interest rate, a move that has been necessary to support the economy, that continues to lose steam, and to prevent deflationary risks. While policy loosening should help to prevent a hard landing for the economy, any sustained acceleration in credit growth would put back efforts to put the banking sector in better shape. Currencies The evolution of the situation in Greece will probably continue to remain one of the most important driver for the performance of this asset class. In fact, the recent price action for the EUR/USD cross has been somewhat counter-intuitive. With the Euro as the new funding currency of choice, it will continue to depreciate if market sentiment remains risk-on. Only and if Greece will be off the limelight, markets will focus back on fundamentals, namely monetary policy divergence, which is EUR/USD negative. Our positive view on the US dollar is therefore unchanged. We also remain bullish on the British pound, as economic data continue to be supportive, fuelling speculation about the timing of Bank of England hike. 4
Credit Investment Grade Still solid credit fundamental remaining supportive for the IG corporates as well as financials. New issuance has been stopped due to the Greek situation, as the market is clearly waiting for an agreement. Nevertheless on a year to date basis, we have faced more than 28% of new issue than last year (and a lot of companies are waiting for the reopening of the market). The good news came from the ECB last week, with the inclusion of 3 Italian corporates names (Terna, Enel, Snam) in the PSPP program. Those 3 names benefit from a large stake of the Italian government in their capital (~30%). It is a positive signal for the market, implying the possibility that corporate could be include soon in the QE program. Liquidity is still thin, resulting from the conjunction of the end of the quarter and the market volatility, impacting trader s balance sheet. High Yield Despite the recent negative trend in performance and the widening of the itraxx Xover, the fundamental pattern has not changed with a European economic environment gradually improving, a default rate still below historical average and the strong support of the ECB. The absence of any massive outflows despite the increased volatility in financial markets is a clear sign of the constant interest of investors for the asset class. We expect the market to stay volatile in July and August given the ongoing negotiation with Greece but also due to the poor liquidity which prevails in summer time. On a pure risk return basis for the Euro High Yield market, single B rated securities stay attractive as their duration is naturally lower with an average yield to worst of 5.40% but BB s are now back in the game with a 3.34% average yield to worst for a much stronger risk profile. Text finalised on July 8th, 2015. 5
Glossary Breakeven: See inflation expectations. Bund: German Treasury bond. Unless otherwise indicated, with a residual life of 10 years. Covered bond: A bond issued by a bank and this is backed by collateral, or a guarantee, most often mortgage loans. Duration: Average life span of a bond or a bond portfolio, including all related flows, i.e., coupons and partial or full repayments. The more a 10-year bond pays out high coupons and makes partial repayments, the shorter its duration. The lower its coupons and the closer its repayments are to maturity, the longer, or higher, its duration. Eonia (Euro OverNight Interest Average): Average euro zone overnight (see this term) money-market rate. Euribor: Benchmark money-market rate for terms ranging from one week to two years. Haircut: A haircut is a percentage that is subtracted from the market value of an asset that is being used as collateral. The size of the haircut reflects the perceived risk associated with holding the asset. Inflation expectation: This is the spread between the bond market yield on a certain duration and the real rate (ex-inflation) as results from the market value of a bond linked to inflation of the same duration. Inflation-linked bond: Bond whose principal is indexed regularly to inflation of the issuing country or the euro zone. The remuneration rate, which is based on the principle plus inflation, therefore offers a real remuneration (ex-inflation). Investment approach: In each region (US, euro zone, and emerging markets) we review the following variables over the medium and long term: growth potential, inflation risk, monetary policy, long bond yield potential, and risk appetite. Money market: Cash market. Banks place their short-term cash on this market or go to it to borrow the funds they need on a short-term basis. See also Eonia, Euribor, overnight rate. Overnight rate: Refers to a 24-hour loan that may be rolled over indefinitely. OAT: French Treasury bond. Unless otherwise indicated, with a residual life of 10 years. Spread: The difference in yield between two bonds with the same maturity, with the former often offering greater risk than the latter. Treasuries: US Treasury bonds. Unless otherwise indicated, with a residual life of 10 years. Variable: See investment approach. All data provided in this document come from the following sources: Datastream, Reuters, Boursorama. The variation listed are calculated from one month to the other. It concerns the indexes established by assessment organism commonly recognized unless stated otherwise (INSEE, IFO - Institut für Wirtschaftsforschung, ZEW - Zentrum für wirtschaftsforschung, GFK - Gesellschaft für Konsumforschung, etc.). The weekly variations of equity indices, the 10-year rate and the exchange rates mentioned in this article are computed or recorded on the last business day of the previous week. 6 Investing involves risk. 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