Strong data for German manufacturing orders in December did not immediately excite European equity markets. This data fits with a recent pattern of broadly positive numbers on the eurozone economy, especially with regard to leading indicators.
Industrial production surged in November, although retail sales volumes fell in November and December (see Exhibit 1 below). Retail sales grew faster in the fourth quarter than in the third, but we may see some negative impact on consumer purchasing power via higher headline inflation.
Exhibit 1 : While eurozone industrial production surged in November, retail sales fell in the last two months of 2016 – graph shows changes in eurozone industrial production and retail sales for the period between 2010 and 2017
Source: Datastream, BNP Paribas Asset Management, as of 06/02/17
Somewhat counter-intuitively, healthy economic data in the eurozone may be less positive for equity markets than one would expect because investors could conclude that a strong economic environment could lead the ECB to start winding down or ‘tapering‘ its asset purchases.
The tapering of central bank quantitative easing (QE) in the US caused volatility in global financial markets, albeit short-lived, but tapering in the eurozone may have a longer-lasting impact.
Firstly, when, in January 2014, the Federal Reserve (the Fed) started tapering, the ECB and the Bank of Japan had their own QE programmes running and were still in the process of increasing their volumes of asset purchases. If the ECB starts tapering this year, there will be no other central bank around taking up the slack via an expanding programme of asset purchases.
Secondly, tapering in the eurozone may have a different impact on the eurozone’s sovereign bond markets. One of the negative effects of quantitative easing is that it suppresses the process of proper price-setting in the markets involved. In homogeneous sovereign bond markets – such as the US or Japan – QE tends to push bond prices to overvalued levels.
In fact, pushing yields down to support the economy is one of the reasons why a central bank undertakes quantitative easing, so a successful asset purchase programme necessarily leads to overly expensive sovereign bonds.
The Fed even went so far as to declare that rising equity prices while it was easing quantitatively would be one of the transmission mechanisms for this form of monetary policy.
In heterogeneous bond markets such as the eurozone, where the market is composed of debt issued by a number of sovereigns with differing credit profiles, quantitative easing also has the effect of suppressing credit risk.
That is, bond yields of sovereign issuers with high debt or large deficits tend to be pushed even lower than those with more healthy government finances.
For example, as the amount of eligible bonds the ECB can buy in Portugal has become more limited, Portuguese risk spreads have widened by almost 200bp from their 2016 lows, pushing 10-year yields to 4.2%.
Risk spreads have widened by 50bp in France due to political risks. While in our view the risk that the Front National takes France out of the eurozone is low, political developments are hard to forecast these days.
In Italy, low growth and high levels of non-performing loans in the banking sector are the main risk, pushing spreads 100bp higher, while in Spain, the strong economy has limited the spread widening to 34bp.
So, the mere prospect of discussion about ECB tapering has led investors to reassess sovereign credit risk in the eurozone. This suggests to us that the ECB should be careful not to fall into the trap of starting its tapering too soon. The time for tapering will come, but it will only be when the ECB’s analysis leads it to conclude that the level of inflation in the eurozone is close to its target or approaching the target on a sustainable basis and economic growth is strong enough for the prop of quantitative easing to be removed.