Dovish ECB Stand Likely to Dominate European Fixed Income Dec 1, 2017

2018 Outlook: “The eurozone’s mix of encouraging growth, weak inflation and dovish ECB policy is likely to continue.”

Over 2018, we expect the direction of European fixed income markets to be determined principally by European Central Bank (ECB) monetary policy and the political backdrop, in much the same way as these two factors have dominated 2017. The eurozone economy appears to be in good shape, the best since the global financial crisis a decade ago, and we think this progress should be maintained. But with little sign of any pickup in inflation, the ECB remains committed to significant levels of quantitative easing until at least September 2018, so its dovish tilt could limit the scope for European bond yields to rise. Nevertheless, political developments—for example, an impasse in the Brexit negotiations—may increase volatility in markets, and investors should be ready to take advantage of such opportunities.

Positive Economic Backdrop Unlikely to Shift Dovish ECB Stance

Our baseline projection sees the eurozone’s cyclical recovery continuing, with increasing confidence among consumers and businesses in the region boosting spending, and a further lift from a supportive global economic environment. The current expansion seems durable and well distributed among the member states. Despite this upbeat outlook, as long as inflation is weak (which consensus forecasts for 2018 indicate is likely), a significant shift in the ECB’s policy is hard to envisage. ECB President Mario Draghi’s repeated insistence that the central bank will not raise interest rates before ending quantitative easing underlines how far away such a move remains. Since his term as ECB president is not due to expire until late 2019, the prospect of any reconsideration of interest-rate policy in the near term seems slight.

The ECB enters 2018 after engineering a shift to a lower level of quantitative easing, while managing to limit a deflationary rise in the euro. Several factors about the central bank’s revised monetary policy are worth noting, as their effects will play out over the year. Though its monthly bond purchases have been reduced from €60 billion to €30 billion, a portion of the ECB’s previously purchased securities are now maturing. As the proceeds are re-invested by the ECB, the result will be to offset some of the reduction in the central bank’s bond purchases, perhaps by as much as a half.

It also appears that the ECB will concentrate on reducing its purchases of government (rather than corporate) bonds, but here issuance is increasing, with the net amount of eurozone government debt set to expand in 2018, in contrast to the contraction seen over the previous 18 months. All in all, we believe eurozone bond yields may move a little higher, but any increase is likely to be capped by the ECB’s ongoing level of purchases, at least until policymakers start to signal their next steps on monetary policy later in the year.

But the Potential for Political Upsets Remains

Concentrating solely on the domestic political events that could influence European markets during 2018, three stand out. Spain’s constitutional crisis seems set to rumble on, as the central government looks to re-assert its authority over Catalonia. Fresh elections in the region, scheduled for December 21, 2017, seem unlikely to provide any lasting solution. So far investors have remained sanguine about the potential damage to the Spanish economy, judging that the ECB’s purchases will continue to support Spanish government bonds. Nevertheless, any further radical moves by Catalan politicians to facilitate their separatist aspirations could hurt growth, given the region’s importance economically to Spain.

Italian elections are due to take place during the first half of 2018, and have the potential to deliver another political upset, although recently there have been signs that populist parties—most notably the Five Star Movement, which according to polls enjoys similar levels of support among Italian voters as the ruling Democratic Party—are toning down their calls for a referendum on Italy’s membership of the eurozone. The better performance of Italy’s economy has tempered backing for such a move.

However, it is the Brexit negotiations that loom largest, as the March 2019 deadline for their conclusion draws closer. If agreement between the United Kingdom (UK) and the European Union (EU) remains elusive during the coming year, the economies of both are likely to be hit. While the UK economy has already shown signs of slowing and would probably feel the greater effect as businesses accelerate their contingency measures for such an outcome, the possible impact on the EU may be significant and remains somewhat underappreciated, in our view.

The decade since the global financial crisis has seen widespread central bank intervention in markets to keep interest rates low. However, these conditions may also have sown the seeds of populism, and investors should be prepared for support for populist parties to remain an enduring influence on European politics over the medium term.

Populism in Europe May Be Here to Stay

Populist versus Mainstream Political Parties, Historical versus Recent Election Performance

10 Years Ago*

Past Election**

Average European Populist Support

*For Spain (2008), Italy (2008), Germany (2008), Greece (2007), the Netherlands (2006), France (2007), Austria (2006), Finland (2007)
**For Spain (2015), Italy (2013), Germany (2017), Greece (2015), the Netherlands (2017), France (2017), Austria (2017), Finland (2015)
Source: National governments, as of 11/6/17.

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