Joining the party

Joining the party

An old saying about this or that economy trying to fix its structural problems is that it’s the opportunity of the future… and always will be. The opportunity never really materialises in full, or doesn’t last long enough. To strategists, sometimes the euro area feels like this. Every time there’s a crisis, it’s impacted to a greater extent than its peer group, partly because of its institutional vulnerabilities – which are nevertheless in the process of being mitigated. Inevitably, at some point, recovery sets in. Occasionally, that’s because a more substantial fiscal stimulus, albeit after a convoluted approval process, eventually comes through – complementing the monetary backstop from the European Central Bank. Other times, that’s because a global rebound lifts exports – a key driver, given high trade openness. Both are happening this time around. Things are looking up in the euro area. But whether there’s still room to surprise the markets to the upside remains to be seen.

Better late than never: The euro area is starting to rebound from the pandemic. The US and UK remain ahead, as faster vaccine rollouts allowed the lifting of most restrictions at an earlier stage and fiscal stimulus in the US turned out to be stronger. But the continental European economies are now beginning to recover too. The medical situation has improved, as Covid-19 case growth has slowed across the region and vaccination is ramping up. So far, consumer spending and services have lagged behind in the euro area. However, the purchasing managers’ indices now show strong gains across sectors, high-frequency indicators on mobility are on the rise, the forward-looking components of key sentiment surveys such as the German Ifo business climate have picked up and the tourism season is about to start in southern Europe. All this points to further gains ahead.

Better dovish than sorry: Risks of premature policy tightening are insignificant. If anything, the risk is overstimulation. Even though the economy is getting better, the monetary stance remains very expansionary and unlikely to change for quite a while. The ECB is likely to upgrade its macro projections next week and may decide to buy assets at a slightly slower pace. But the central bank’s strategy review, which we expect to conclude over the next few months, should deliver a 2% symmetric inflation aim (rather than “below, but close to” as currently) taking past inflation into account. This, plus an enhanced forward guidance, should ensure highly accommodative financial conditions for the time being. What’s more, the EU recovery fund – which focuses on public investment – offers an opportunity to sustain growth after the reopening, especially in the periphery.

Here’s why this matters:

Bund yields and the euro: Bund yields have continued to rise lately. A modest reduction in the pace of asset purchases at the upcoming ECB meeting may push them somewhat higher. As a result, we see risks of exceeding our year-end forecast of slightly negative 10-year yields, perhaps getting to something closer to zero sooner rather than later. For now, however, we do stick to our base case, as the central bank’s rhetoric seems to have become more dovish – probably because financial conditions have tightened somewhat and sovereign spreads have widened recently. The economic rebound in the euro area, along with rising bond yields, is the likely driver of the euro appreciation versus the US dollar. We don’t expect these conditions to persist: Fed tapering will probably put more upward pressure on US Treasury yields, potentially making the dollar more attractive again.

Euro area equities: Recently, we tactically added global equities to our portfolios and further reduced the exposure to euro government bonds to fund the overweight. We also looked at the case for euro area equities. However, we concluded that these economic and market dynamics have been widely anticipated by equity investors – and fast. Certain macro narratives could still apply to euro area stocks. The performance of bank equities relative to the broader index is correlated with the steepness of the Bund yield curve – they could still benefit in relative terms, though perhaps not uniformly. With the ECB promising to keep its key policy rate unchanged until inflation is “consistently” on target, the short end of the curve is set to remain anchored in negative territory, while long-term bond yields could rise as the economy improves and, eventually, the central bank buys slightly less.

Meanwhile, strong data continue to clash with policy dovishness…

Tough job for central banks: Markets will likely watch Friday’s US jobs report very closely after last month’s payroll miss – for any indication that job creation is accelerating again and joblessness is resuming its decline. Based on very strong readings for the purchasing managers’ indices, the ISM surveys are likely to point to robust activity across manufacturing and services. On the inflation front, core PCE surprised to the upside last week. We expect the Fed to continue to describe these dynamics as mostly transitory. Over the next few months, the central bank should announce that it will taper its asset purchases, but we see no rate hike for the next 2.5 years. In the euro area, most of the rise in inflation is due to commodity prices and base effects – the core rate, which strips out volatile components such as energy and food, is likely to have remained quite low this month.

Daniele Antonucci | Chief Economist & Macro Strategist