What effect do you think the ECB’s latest package of stimulus will have on the eurozone economy and interest rates?
OL: The European Central Bank’s (ECB) decision to extend the emergency bond purchase scheme to mid-2021 and increase it to EUR 1.85 trillion is important. The ECB has already done a lot, but this additional package of measures will reassure markets as to the ECB’s policy intentions. The ECB is now effectively implementing yield curve control. It will buy most of the new debt eurozone governments are issuing to overcome the pandemic. Just recently, Spain issued sovereign debt for the first time with a negative interest rate. With interest rates so low, the market needed confirmation of the ECB’s policies.
In my view, it is clear that the ECB is applying the lessons drawn from the experience of other central banks. We know that within the ECB, there was a strong debate about the measures. President Christine Lagarde was able to build a consensus after policymakers discussed an expansion of between EUR 500 billion and EUR 750 billion.
We saw markets rally on the decision. Bond yields on the bloc’s ‘periphery’ fell, suggesting that the measures will give a boost to nations such as Italy and Spain. Investment-grade corporate bonds also stand to benefit from the decision.
This latest package of measures is of particular importance to the small and medium enterprises (SMEs) and households in the eurozone. The ECB’s measures provide them with liquidity via the banking sector. We have seen a significant rise in lending due to these guaranteed loans that are of great importance to the eurozone economy.
How pertinent is the idea of ‘Japanification’ of the eurozone?
OL: I have been hearing this comparison with Japan’s economy for a long time. There are some similarities – weak economic growth, disinflation and now yield curve control – but I see two important reasons as to why this comparison is inappropriate:
- The relative strength of the banking sector in the eurozone. In the 1990s, Japan was plagued by a chronically weak banking sector struggling with non-performing loans. This is not the case in the eurozone today. The coronavirus pandemic is a major challenge. It will weigh on default rates, but the ECB is doing everything it can to contain the risks, so it should be manageable.
- Secondly, the labour force. Unemployment is high in Europe compared to where it was in Japan. You could see that as meaning the situation is worse, but I see it the other way around. To my mind, this creates scope for economic growth, if and it’s a big ‘if’, the situation gets better. I see this as a source for hope.
These factors constitute major differences between what happened in Japan and what is likely to happen in the eurozone over the long run.
What is your outlook for eurozone bonds in 2021? Where do you see opportunities?
OL: Yields on sovereign debt in the eurozone are very low (see Exhibit 1 below). Since the ECB flagged in October that it would expand its bond-buying programme, yields on greater swathes of southern European bonds have sunk to below 0%. I have not been saying this for a long time, but I do now think that eurozone bond yields are now probably close to as low as they can get.
When asked about the outlook for 10-year bond yields, I start by looking at the yields for two-year sovereign bonds. Today, yields on two-year German sovereign debt are close to minus 80 basis points. At -0.50%, the ECB’s deposit rate is already among the lowest in the world. Central bank studies suggest that somewhere around -1% constitutes an equilibrium level for eurozone sovereign bond yields. We are now close to this level, which I see as a floor.
If I think that two-year yields are close to as low as they can go, how low can 10-year yields go? The answer is that they cannot go much lower than current levels because the yield curve is already extremely flat. Most of the fall in 10-yield eurozone bond yields is behind us.
Then there is the longer end, where the curve between 10-year and 30-year sovereign debt is steeper. We see investors switching between eurozone sovereign debt and corporate debt depending on the steepness of the curve and spreads on corporate debt. Credit spreads have tightened a lot and we are seeing investors switch back into sovereign debt.
That may seem surprising, but the European Union's (EU) recent issuance of long-term bonds demonstrated the appetite for these new bonds. The EU will be an important source of issuance in 2021 and we see demand for the longer-dated bonds.
At current levels, opportunities are limited on 10-year eurozone sovereign debt. Italian sovereign debt has performed well recently, with the yield of 10-year bonds falling from 1% in September to around 0.50% today. I would see it as the only sovereign market with further scope, with a further fall of 0.2-0.3% possible.
With regards corporate debt, spreads are already tight (see Exhibit 2 below), but I do see opportunities among the fallen angels. At some point in 2021, there will be recovery trades on this year’s worst performing sectors, such as real estate or some of the major airlines.
We also like the eurozone banking sector. We have favoured the banking sector for a long time now in our portfolios, particularly subordinated debt. We think the new conditions for the TLTROs announced by the ECB provide further strong support, but the most positive news has been the guaranteed loans to households and SMEs. This should be beneficial to the banking sector.
To summarise, in developed bond markets and particularly in the eurozone, we see the most attractive opportunities in spread products in specific sectors.
Are you more concerned about the risk of deflation or inflation in 2021?
OL: There is a very different outlook between the US and Europe.
In the US, everything is in place for higher inflation – fiscal stimulus, an economic rebound in 2021, rates at historic lows – towards the end of 2021. That would be a positive outcome. If we look at the salary increases anticipated in the National Federation of Independent Business survey (NFIB) in the US, we see evidence of a strong rebound in the intentions to raise salaries.
In the eurozone, the outlook for inflation is very different. Unemployment here is too high to leave much room for significant salary increases. The sole possible sources of inflation I see for 2021 in the eurozone are technical – higher VAT in Germany, some base effects due to changes in calculating inflation.
Low inflation and the risk of deflation is the number one risk for the ECB in 2021. For this reason, the ECB will be following developments on the euro in foreign exchange markets closely. Any rapid appreciation could lead to action from the ECB to counter the potential impact on inflation in the eurozone.
Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. The views expressed in this podcast do not in any way constitute investment advice.
The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.
Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).
Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.