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In its quarterly Fixed Income Outlook, Robeco signals clear improvement in economic data. ECB officials are openly discussing how to exit their monetary easing policy. As central banks in developed countries are gradually moving on with their policy normalization, interest rate risk should be managed closely.
While there is much attention for the divergence between hard and soft data in the US, there is a remarkable development in the euro area that receives much less attention. Over the past months, economic data for a broad range of countries and on a broad range of areas has started to look quite a bit more promising.
Export growth has improved remarkably. EMU wide exports are up 13% year-on-year, against around 0% growth only three months earlier. And it is not just Germany. Finnish export growth is up 9%, Portuguese exports up 13% and for most countries in between growth is similar. Increased exports orders have probably helped push up confidence. Manufacturing confidence in the Netherlands has risen to the highest level since 2011 (when the ECB was hiking rates) and for many countries confidence is close to that level. Higher confidence is also visible in business fixed investment. Capital spending is growing at close to 2% in Portugal and 4% in France and for most countries growth is similar.
Labor market data continue to improve at a steady pace and provide a positive backdrop for consumer spending. Over the past twelve months, unemployment in the euro area has come down by 0.8 percentage points to 9.5%. For the EMU as a whole, unemployment is already below the 2011 level and only 2% away from the 2008 low. Italy and France are noteworthy exceptions, but overall the steadily improving labor market conditions are a strong support for consumer spending. Consumer confidence is close to the highest level since 2007, which is also the highest level since 2001. This bodes well for consumer spending, which currently grows at around 2%.
In spite of the brighter growth outlook, inflation pressures are still absent. Core inflation has been in a range between 0.6% and 1.1% since mid-2013 and seems firmly anchored. Even in Germany – with unemployment at the lowest level since the re-unification - wages are growing only modestly (2-3%), so upward pressure from labor costs is limited. Still, deflationary pressures are no longer prevalent, which at least counts for some progress. Improvement is visible across a broad range of countries and across different areas of the economy. A trend which has received little attention so far.
These are our key themes:
Discussion amongst ECB policy makers on the sequencing of the exit strategy is out in the open. According to Draghi, a reassessment of the current policy setting is premature. Others like Weidmann believe a discussion is warranted on the current forward guidance to keep key interest rates ’at present or lower levels for an extended period of time, and well past the horizon of our net purchases’.
Hiking official target rates before ending the bond purchase program would have the benefit of limiting drawbacks of negative rates, such as downward pressure on bank profitability. At the same time, the scarcity of German government bonds (due to the self-imposed 33% issue/issuer limit) speaks in favor of phasing out the asset purchase program first. We lean to the latter scenario.
In the US, the March Fed minutes reveal that the balance sheet reduction starting as soon as this year has become a real possibility. It is conceivable that political pressure is behind the shift to bring this reduction forward. Such a move could imply that the rate normalization process will take a bit longer.
As central banks in developed countries are reacting to a more benign growth and inflation outlook and are gradually moving on with their policy normalization, interest rate risk should be managed closely. Currently we avoid interest rate risk in short-dated US securities and also have limited duration exposure in the long end of the European bond market.
In the aftermath of Trump’s election emerging local debt performed poorly, but the first quarter showed a strong recovery. Especially versus other fixed income categories valuation remains appealing. This has attracted interest from global asset allocators. The universe’s fundamentals are a mixed bag with political risk in countries like Turkey and South Africa on the rise.
In the course of the first quarter, we added interest rate exposure in Mexico. The central bank has reacted in a responsible and orthodox manner to a rise in inflation. We envisage outperformance of Mexican local rates markets going forward.
German government bonds posted a big outperformance versus their European peers year-to-date. French and Italian sovereign spreads are at multi-year highs. As the ECB is tapering its purchases, the safety net for the European bond market is gradually being removed. We expect dispersion between countries to increase. Given the poor fundamental outlook for Italy we are biased to trade this country from the short side. In France recent spread widening is directly linked to political risk. A Macron election victory will most likely drive spreads lower.
Our preferred credit category is subordinated financials. Their valuation is attractive versus other credit categories. Furthermore, an environment of rising yields and steeper yield curves is supportive for the financial sector. We are cautious on Italian and German issuers and constructive on financial institutions from France, Switzerland and the Netherlands.
Overall, we maintain our cautious stance on credits. Valuation is nearing expensive levels in most credit categories. Especially in the US, corporate leverage is high again. The credit cycle is maturing and investors should take note.