Macro Outlook and Portfolio Implications—A Team Perspective


- The ECB has embarked on a new chapter, committing to maintain an accommodative stance including asset purchases until its inflation target is clearly within reach. President Draghi has also emphasized that the policy stance supports expansionary fiscal policy.

- While these measures are welcome, we doubt they will prove adequate. Fiscal authorities are unlikely to engage in timely and sufficient stimulus to forestall a weakening growth outlook. And monetary policy is less effective in the face of tepid household and business loan demand.

- On the portfolio front, these measures will support European investment grade and high yield credit markets in the short run. But with little compensation for risk, we remain underweight the euro area in credit portfolios. Where applicable to specific portfolios, our conviction trades revolve around moving portfolios up in quality, shortening spread duration, diversifying alpha sources and increasing interest rate sensitivity.

Recent years have seen advanced-economy central banks respond to a sluggish growth and inflation outlook with further forays into the unconventional policy toolbox. Earlier forms of limited quantitative easing and date-based guidance to keep rates low for long have been replaced by more muscular and open-ended commitments. The Bank of Japan was one of the early pioneers of these efforts, with a commitment to expand its balance sheet until certain inflation outcomes are met. The European Central Bank (“ECB”) has recently followed in a similar path, explicitly committing to keep its policy rates at current or lower levels until the inflation outlook is converging to the central bank’s inflation target. New asset purchases are also tied to the inflation outlook, albeit less directly. These changes represent an important evolution in the ECB’s policy strategy. For the first time, there is a relatively open-ended commitment to keep rates low and maintain asset purchases at least until the inflation objective is within reach. This evolution suggests that these easing measures could remain in place for years to come.

There may be diminishing returns from successive rounds of easing, but such policy innovations can still have meaningful market effects. Indeed, 10-year German bund yields are approximately 30 basis points lower than they were at the time of ECB President Draghi’s June Sintra speech, when these policy measures were first telegraphed. Peripheral spreads have also narrowed since that time, while the Euro STOXX Index has outperformed the S&P 500 and the euro has depreciated against most other major currencies.

While the ability of ECB easing to alter financial conditions is still in place, we remain skeptical that the most recent actions will have a meaningful impact on growth and inflation in the years ahead. First, policy transmission to peripheral Eurozone countries has been, at best, imperfect. Successive rounds of policy easing have failed to lift household borrowing in the periphery in a meaningful way. Non-financial corporate borrowing has been even more anemic. At best, this latest round of easing measures ensures a conducive environment for credit, but will likely have little effect on the demand for funds unless expectations for growth shift meaningfully higher.

An additional issue is that the German economy has already begun to slow, and in the third quarter it will likely register a second sequential decline in quarter-on-quarter GDP growth. Household consumption has held up reasonably well, but is at risk if a challenging external environment leads businesses to pull back on hiring. Given the slowdown already underway, the ECB’s policy innovations may ultimately prove to have arrived too late to stave off a weaker growth outcome. (Figure 1)

Further, while the state-dependent nature of the policy guidance is a welcome change in strategy, the shift was not as forceful as it could have been. Specifically, the ECB is still not convincingly demonstrating that it treats its inflation objective symmetrically. The latest language change suggests that the inflation objective is still a ceiling, and that policy-makers have limited tolerance for inflation rising above the objective:

“The Governing Council now expects the key ECB interest rates to remain at their present or lower levels until it has seen the inflation outlook robustly converge to a level sufficiently close to, but below, 2% within its projection horizon, and such convergence has been consistently reflected in underlying inflation dynamics.” 1

This shortcoming is all the more glaring against the backdrop of the Bank of Japan taking a more forceful approach, committing to policy easing measures until it has achieved an inflation overshoot. Similarly, the conditionality in the above guidance is open to interpretation. For example, would core Eurozone inflation firming to 1.2 percent (from 0.9 percent currently), and projections showing inflation at 1.75 percent at the end of the ECB’s projection horizon, meet the above criteria for raising rates? The uncertainty over criteria, along with the ongoing perception that the ECB might not tolerate an inflation overshoot, weakens the effect of the guidance on financial conditions and household and business spending decisions.

Finally, in his press briefing following the policy decision, President Draghi suggested that the ECB has largely done everything that it can, and now it is up to fiscal authorities to take steps that will boost aggregate demand as well as the supply side of the economy. While we agree with the sentiment, we are skeptical that fiscal policy will be employed proactively to reduce risks of a material slowing in growth. There are some positive developments. In the Netherlands, the government’s 2020 budget proposes a meaningful fiscal easing to insulate the economy from downside growth risks. But this looks to be more the exception than the norm. The most likely scenario is that across the euro area, fiscal easing will not be delivered in sufficient size and quickly enough to prevent a further slowing in growth.

Draghi’s message to elected officials also poses risks. With its efforts to lower rates across sovereign curves conditioned on the inflation outlook, the ECB has created significant runway for expansionary fiscal policy in the years ahead. However, by signaling that the central bank has now largely done everything it can to stimulate growth, the ECB risks signaling that monetary policy will remain on the sidelines. If fiscal authorities disappoint, or growth weakens further, this signaling could have the unintended consequence of depressing household and business sentiment.

Investment Implications

In the near term, European high yield and investment grade markets can continue their outperformance versus the U.S. on the purely technical basis of the ECB’s new easing measures. Asset purchases in combination with the new interest rate guidance will continue to suppress the term structure, incentivizing investors to move into spread markets. The potential reactivation of corporate bond purchases is another support pillar for European credit spreads. Additionally, with more significant policy easing in the euro area than in the United States, dollar strength is likely to persist. This will keep foreign exchange hedging costs elevated for foreign investors in dollar-denominated corporate bonds, providing additional support for European credit on a relative basis.

Still, we view any potential outperformance of euro-area spreads to be temporary. Given that we are starting from such low yields, and indeed many of them negative, there is very little compensation for credit risk. On a historical basis, the fundamental metrics are stretched, leaving little room for error. Consequently, as long-cycle investors, we remain underweight the euro-area in global high yield and investment grade portfolios, as we see better risk-adjusted opportunities elsewhere.

Sector-specific considerations also inform our thinking. Further strains in cross-Atlantic trade relations may occur, which would put the manufacturing-heavy European high yield sector at risk. As for investment grade, financials — which comprise a large portion of the index — face a challenging road ahead. European banks have made significant progress over the last several years in addressing weak capital levels and reducing the stock of non-performing loans. But we believe the very real prospect of negative rates for years to come will pressure net income margins. Retail deposit rates are unlikely to fall further, while at the same time new loans will be booked at spreads below the existing book of business. We recognize that deposit tiering will provide some modest offset to these pressures (Figure 2). We are less optimistic, however, on the effects of the new targeted long-term refinancing operations. Given a weak economic backdrop, European loan demand is likely to remain weak, with downside risks given sluggish performance of the German economy.

We take a similarly cautious view on ECB actions in our multisector portfolios. The latest easing measures are certainly positive for investor confidence and reinforce accommodative financial conditions, but we believe their ability to generate sustained excess returns is limited. Compensation for risk in European fixed income markets is not nearly as compelling as it was when the initial long-term refinancing operations helped relieve stress on financial markets during the European sovereign crisis of 2011. As a proxy, senior bank spreads in Europe are in fact close to the more recent historical tights of early 2018.

Across all of our portfolios, we continue to focus on generating excess return by executing our late-cycle playbook of harnessing the income potential in the market through careful research and portfolio construction. Our strategy is focused on diversified sources of return, where in global portfolios European assets play a complementary rather than dominant role. We believe this approach will allow investors to participate in the market while protecting portfolios from future volatility and drawdown potential. Where applicable to specific portfolios, our conviction trades continue to revolve around moving portfolios up in quality, shortening spread duration, diversifying alpha sources and increasing interest rate sensitivity.

1 Statement from the ECB following policy meeting on September 12, 2019.