8-05 3 Things the European Investment Grade Fixed Income Team Talked About Last Week

1. French Election Result …

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By David Greene – Pioneer


As was widely expected, the second round of the French Presidential election yesterday saw Emmanuel Macron win by a comfortable majority, gaining 66% of the votes cast to 34% for Front Nationale’s Marine Le Pen. At 75%, the turnout rate was the lowest since 1969 when George Pompidou was elected. Attention now switches to the national assembly elections in June to see if Macron’s En Marche party can gain an overall majority, or whether they will need to form a coalition with another party. Traditionally there is a significant boost for the party that wins the Presidential election in the assembly elections, but it’s harder to call this time given that Macron doesn’t represent one of the established parties. The only opinion poll published so far shows Macron’s En Marche party with a slight overall majority. The newly-elected President has campaigned on a reformist agenda, promising firm-level negotiations that may include more flexible working hours and spending cuts to finance simultaneous cuts in corporate taxes. At close to 55% of GDP, French government spending is considerably higher than the Euro-area average of over 46%, and Macron has pledged to cut this to 52%, as well as reducing France budget deficit to 1% by 2022. All this will be music to the ears of Angela Merkel in Berlin, with Macron a strong pro-European leader. What will be less interesting to Mrs Merkel (and particularly Mr Schauble, Germany Finance Minister) is Mr Macron’s promotion of common Eurobonds, which is still very much a no-no in Germany. From a market perspective, much of the anticipated tightening of French government bond yields against German bonds has already happened. What may drive the next leg of tightening is whether Asian investors return to embrace French sovereign bonds as one of their favourite European debt instruments. Those investors have traditionally regarded French sovereign bonds as quasi-German debt but with a higher yield, but they sold large portions of their substantial holdings in Q1 2017 ahead of the elections. Should we see a return of these investors, looking to increase their French holdings, it could drive the French/German sovereign spread tighter.

2. What have the cities of Wellington and Edinburgh got in common?

A recently-published survey[1] of global prices of goods and services from 47 major cities across the globe was released last week, and gave rise to some very interesting figures. By converting all prices back to U.S. Dollars, the authors were able to make comparisons on various items such as Healthcare, Safety, Commuting time and Pollution amongst many others. Perhaps somewhat surprisingly, Wellington in New Zealand was rated the best city to live in from a quality of life point of view. Whilst scoring somewhat expensive on the Healthcare and cost of living indices, Wellington really came into its own on the Property Price to Income ratio, Traffic Commute Time and Pollution indices. Edinburgh in Scotland came out second of the 47 cities, and Dublin was ranked 21st, ahead of Milan (29th), Paris (30th) and London (33rd). Citizens of Zurich are the highest paid, averaging a month salary of US$5,876 net of taxes, with San Francisco, Boston, New York and Chicago filling the next 4 spots. Unsurprisingly, San Francisco was the most expensive city in which to rent a mid-range two bedroom apartment, at a cost of US$3,449 per month, followed by Hong Kong, New York and London. If you fancy a quick weekend break, it’s probably best to avoid Milan, which rates as the most expensive destination, mainly due to the very high cost of its hotels. Better to head to Istanbul, which was the cheapest of the 47 cities. And whilst people in Zurich take home the biggest monthly net salaries, they will spend most of that if they are looking for love, as Zurich was rated the most expensive city in which to go on a date. Inhabitants of Manila, Jakarta and Kuala Lumpur will find their cities the cheapest of the 47 if they are single. If you like beer and cigarettes, make sure you avoid Oslo, Melbourne, Auckland or Sydney, and instead head to Prague or Warsaw. The more serious part of the report is a debate about whether Purchasing Power Parity corrects itself over time. In theory, exchange rates should adjust (even if it takes a number of years) when there are large price differentials. But these reports also help investors get an idea of those regions that are generally cheap or expensive, and can be a useful input into investment decision-making.

3. Falling Oil Price = Rising Real Yields

The oil price came under sustained downward pressure last week, falling at one stage to below US$44 before recovering to close above US$46. A number of reasons have been advanced for the decline – a recovery in the U.S. rig count, with an average of over seven rigs a week being added over the last year, concerns about the Organisation of the Petroleum Exporting Countries (OPEC) cuts agreed earlier this year translating into actual lower OPEC shipments, and reports from the Energy Information Administration (EIA) that oil reserves are falling at a lower-than-expected rate. Whilst OPEC have made reassuring noises about extending their production cut agreement again in May, they must surely be concerned about the lack of impact of their original cuts on the oil price. The original deal was announced in late November 2016 and implemented in January 2017, and today’s oil price is lower than both those dates. We noted in last week’s blog about the problem that falling inflation expectations cause for global central banks, and in particular the ECB. At close to 1.60%, European 5-year inflation expectations in 5 years’ time are back to levels not seen since November 2016. Remember, a nominal bond yield can be decomposed into an inflation component and a real yield component. So if Euro-area bond yields are rising, but inflation expectations are falling, it must mean that real yields are rising. One of our themes for the past couple of months has been that global real yields (but especially in Europe), in our view, are too low, and that they should rise as monetary policy normalises. Last week saw some evidence of that, with global real yields rising by more than breakeven rate fell, so pushing nominal yields higher. We also expect a rebound in the oil price, so at some stage this should translate into higher breakeven rates as well, further increasing the upward pressure on nominal bond yields. As noted above, we have been expecting this move, and have been positioned for it in Euro rates. One swallow doesn’t make a summer, but things are beginning to move in the right direction.

 

Source: Barclays, Bloomberg Research, data as at 08 May 2017.

[1] Deutsche Bank, Market Research, “Mapping the World’s Prices 2017.”

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