External factors such as uncertainty over the Brexit process appear to be leading some investors to doubt there will be any meaningful re-acceleration of growth in the eurozone, although recent 'soft data' suggests consumption is resilient.
- Inflation is sluggish
- BEI rate plummeted between November and March
- Various factors could limit the potential rise in core government bond yields
Over the first quarter of 2019, we held the view that the slowdown in eurozone economic growth was largely due to external weakness, and that concerns over further external shocks should gradually ease given the dovish stance by major central banks around the world, along with policy easing measures by the Chinese authorities and the de-escalation in US-China trade tensions.
At the same time, we believed that favourable financial conditions, further improvement in employment and wage growth, as well as a more expansionary fiscal stance in major eurozone member states, should continue to support private consumption in the eurozone.
With our base case assumption that the eurozone economy should grow at slightly above trend, albeit below 2017 levels, and our expectation that worst-case concerns over an economic slowdown would not materialise, our inflation-linked bond portfolio was positioned with a modest duration underweight and a long breakeven inflation (BEI) rate position to capture a potential recovery in risk sentiment.
Eurozone inflation developments: still lacklustre
However, despite some early signs of recovery in eurozone economic activity, the extent of the improvement in Q1 was too modest to reassure many investors on any meaningful economic reacceleration given the lingering risks from external factors and Brexit-related uncertainty.
At the same time, inflation developments are lacklustre. Revisions to Germany’s inflation data due to a methodology change led to an unfavourable one-off impact on the unrevised eurozone Harmonised Index of Consumer Prices (HICP) ex-tobacco to which inflation-linked bonds are referenced. Our eurozone active positions suffered as a result and detracted slightly from performance.
Looking ahead, recent incoming data has reinforced our view that we have probably already seen the trough in global growth. Purchasing managers’ index (PMI) surveys are showing early signs of a bounce-back in Chinese growth, and we expect the easing measures announced by the Chinese authorities to continue to pass through to the real economy and keep growth moving in the right direction.
In the eurozone, while the manufacturing sector is slow to recover, there are signs of more green shoots across member states. Recent eurozone services PMI surveys have confirmed our view that private consumption is resilient.
BEI rate: historically large fall
In breakeven inflation, having spent much of 2018 gyrating within the 1.6% to 1.8% range, the 5-year/5-year forward BEI rate started to fall precipitously last November to a low of around 1.3% in March. The drop is large by historical standards, and reflects the deceleration in both global and eurozone growth, expectations that eurozone inflation will remain low, and scepticism over the ECB’s ability to deliver on its inflation target given its constrained policy tools.
The inflation picture will likely be murky in the near term as volatile seasonal changes in holiday package prices around the Easter holiday will make inflation data difficult to read. The recent growth worries may also slow the process of higher wages passing through to inflation. Our near-term view is that eurozone BEI rates offer some tactical value, as we remain optimistic that economic activity will recover in the coming months.
We see the ECB’s discussion about “tiering” as a sign of preparing for potential additional easing should economic growth disappoint further. Such action may relieve investor concerns about the ECB running out of ammunition.
Adverse scenarios may be priced in, longer term
We expect the combination of economic green shoots, an ECB more prepared to ease, and positive inflation carry seasonals to help BEI rates recover in the near term. Over the longer term, however, if the growth momentum continues to stall and if the disinflationary shock intensifies, we see increasing risks of the market pricing in a higher probability of adverse scenarios, such as deflation, given that central bank policy rates will likely still be close to the “effective lower bound” and given the political hurdles to returning to sizable quantitative easing programmes.
In terms of duration, we held a modest tactical underweight in duration early in the year as we saw asymmetric risk-reward tipped in favour of higher yields in front of the wall of government supply scheduled for January.
However, we were quick to exit the position, at a small loss, after we saw that the market absorbed the new issuance well and German Bund yields continued to hover at low levels given the lack of economic recovery.
Various factors could limit rise in core yields
More recently, we have started to re-establish a modest duration underweight in core eurozone countries, motivated by the concern over a manufacturing slump and external weakness dragging domestic activity down dissipating, and the apparently diminishing probability of a disorderly hard Brexit.
Over the longer term, however, we see
- the backdrop of low inflation
- lingering threats of US tariffs on German car exports
- unresolved political and fiscal issues in Italy.
In core yield curves, we have gradually moved our inflation-linked bond holdings from the intermediate sector to the shorter end of the real yield curve to capture the turn to more favourable inflation carry seasonals in the coming couple of months.
In 'peripheral' yield curves, we held a modest flattening exposure to express our defensive view. In Italy, while some of the major risk events such as the rating agency decisions and the budget fight are behind us, we expect the bond market to continue to be clouded by uncertainty and volatility.
Recent macroeconomic developments are not encouraging – real GDP growth has slowed; inflation has remained subdued, and consumer confidence remains soft. Italy’s low potential trend growth and the related structural weakness remained unresolved. We also see a disconnect between the optimism of the new European Parliament being more friendly in relation to Italy’s fiscal reality and see a high likelihood of volatility returning to the Italian government bond market.
This is an extract from the Q1 2019 Inflation-Linked Bonds Outlook published in March. To read the full version, click here > For more articles by Cedric Scholtes, click here > For more articles by Jenny Yiu, click here > For more articles on fixed income, click here >