1. Euro-area Inflation – Breaking the Market…
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By David Greene
The Urban Dictionary defines the phrase “Breaking the Internet” as causing a large commotion on the World Wide Web with many social networks and news outlets discussing the same thing. Last Friday the release of the April Euro-area inflation numbers came close to being the market’s equivalent of “breaking the internet”. Headline inflation jumped from March’s 1.5% to 1.9%, slightly higher than the market expected (remember March’s number had dropped from February’s high print of 2%), but the real shock was the core rate. Since September 2013 this rate has averaged 0.8% and only once (in October 2015) did it print above 1%. Therefore, April’s core inflation print of 1.2% was a real eye-opener, bouncing from 0.7% in March. It came a day after ECB President Mario Draghi noted that there had been no improvement in underlying inflation pressures (more on this below). So what’s going on? Is it a sign of a long-awaited break higher in inflation or a head-fake? Realistically, it’s probably more of the latter. Firstly, April’s numbers were heavily distorted by the timing of Easter. Secondly, there is little concrete evidence as yet of a sustained pick-up in wages and salaries. Our inflation specialist thinks we have seen the peak in both headline and core inflation for 2017, with a gradual drift lower over the summer before stabilising in the autumn. So whilst in the medium-term we remain of the opinion that inflation breakevens and real yields should move higher, the next 6-9 months could see a lack of significant inflationary pressures. Which gives the ECB a problem…
2. ECB – A Supertanker starting to Turn?
As well as his often-displayed consensus building skills, ECB President Mario Draghi also showed us at last week’s press conference that he was quite happy to engage in some banter and mild flirtation with the assembled journalists. In fairness, the last 5 minutes of the press conference were the highlights of what was an otherwise boring affair. Draghi was at pains to draw the distinction between the outlook for growth and the outlook for inflation. On the former, whilst the introductory statement maintained that the “risks remained to the downside”, the ECB President noted the recent improved data, and talked about the growth profile having moved to a “more balanced configuration”. Assuming that the second round of the French election proceeds according to the polls and Emmanuel Macron is elected President, the next set of ECB staff forecasts (to be unveiled at the June meeting) should allow the ECB to adopt a more balanced outlook on growth. In turn, that would also allow the ECB to drop the current references to an easing bias in the deposit rate and further extension of their bond-buying programme. But then Draghi, when answering a journalist’s question, took the opportunity to highlight that there had been no discussion on the inflation outlook. In some respects that isn’t really surprising – since the last meeting there has been plenty of data pointing to higher economic growth, but there has been almost no data pointing to a pick-up in inflation. And whilst the April numbers released on Friday had everyone talking, the ECB is likely to take a more balanced view, knowing that the noise around the low print in March and higher print in April is caused by the timing of the Easter holidays. Again responding to a question, Draghi reminded his audience that the ECB targets inflation, not growth, and therein lies the ECB’s problem. Whilst the stronger growth outlook should cause price pressures to build, the longer it takes for sustained, Euro-area wide core inflation to increase, the harder it will be for the ECB to start an aggressive taper. The market is expecting an announcement of further tapering measures at the September meeting, but what happens if core inflation is still stuck around 1% at that stage?
3. Italian Government Bonds – Risk or Opportunity?
If all goes according to the polls, next weekend should see the election of Emmanuel Macron as the next President of France. With opinion polls in Germany showing that far-right AfD party are losing support and unlikely to make significant gains in the national elections, it looks like we might have passed “peak political risk” in Europe. In theory, that should be good for peripheral European sovereign spreads. Indeed, French government bonds have tightened by some 20bps from the widest levels seen back in early April, and we might expect some further tightening post the final result next weekend. Portuguese bond spreads have been ripping tighter in the past month, so what to make of Italian sovereign spreads, which are actually wider against Germany since the start of the year, making the Italian market one of the worst performing bond markets year to date? Well, there is still a large amount of political uncertainty in Italy. The PD party met over the weekend to re-elect Matteo Renzi as leader, amidst speculation as to the timing of the next national election – although spring 2018 looks the likeliest date, there are still some suggestions that Renzi might favour an autumn 2017 election. But with the anti-Euro 5-Star Movement riding high (some recent polls showed them 5% ahead of the PD’s), that might be a risky gamble. Then there’s the matter of the ECB tapering. Recent figures show that the biggest buyer of Italian debt in the last year has been the ECB, with domestic banks and overseas investors continuing to reduce their exposure. Investors are rightly concerned about what might happen when the ECB stops buying bonds. Thirdly, there’s the ongoing issue of a lack of any serious structural reforms, which means the strong recovery in Euro-area growth is likely to largely bypass Italy. We currently have a neutral stance on Italian sovereign bonds, but bearing in mind all the factors above, our preference would be to sell into any tightening of spreads rather than buy any widening of spreads.