The March European Central Bank (ECB) meeting all but solidified that a lower for even longer euro area interest rate environment is likely. In the face of slowing growth and persistently low inflation, ECB President Draghi pulled on the only two accommodative levers left in his toolkit: 1) a promise to keep rates at the current level “at least through the end of 2019” (whereas prior it was “at least through the summer of 2019”); and 2) another round of targeted longer-term refinancing operations (TLTROs) to keep low-cost liquidity flowing to the economy.
Despite these accommodations, the ECB still expects inflation to stay below mandate-consistent levels through 2021, suggesting more accommodation is warranted. Herein we detail why, in our view, a lower for even longer euro area interest rate environment is likely, and offer potential solutions that may increase yield in such an environment.
Challenging road ahead for the recovery
Despite arguably the most accommodative European monetary policy stance on record, the economic outlook in Europe has deteriorated over the last 12 months. At this time last year, the Manufacturing Purchasing Managers’ Indices (PMIs, an indicator of the economic health of the manufacturing sector) of the five largest European Union (EU) economies were all strongly in growth territory. Furthermore, Germany’s Manufacturing PMI—the largest economy in the EU—was at a post-crisis high. Fast forward to today, the manufacturing sector has slowed considerably, and Italy is in a technical recession. The ECB expects GDP growth of just 1.1% this year, and we agree. Furthermore, in our view, inflation should remain far from mandate-consistent levels.
During the second half of last year, President Draghi consistently cited “external factors” as driving the slowdown in the euro area economy. Specifically, he cited the rise of populism and protectionism, and the slowdown in China growth. While there are some green shoots, neither of these factors look poised to materially reverse in the near term.
Populism. Rooted in inequality, the euro area recovery has been anything but equal. Unemployment rates across the euro area vary widely, and in most jurisdictions, the unemployment rate is higher today than what it was pre-crisis (Germany is the only exception). Furthermore, young citizens have been all but left behind; youth unemployment rates in Italy and Spain are 35% and 39%, respectively. As you might expect, wages have been equally dispersed, and without a narrowing in employment opportunities across countries, it’s hard to imagine that inflation pressures will unify.
China. The economic slowdown has been driven by global trade disputes and waning stimulus measures from 2015 and 2016. Roughly 30% of euro area exports go to Asia, so when China slows, euro area exports slow. Chinese authorities have been adding stimulus of late, so some rebound in trade is likely. However, the abundance of leverage in the Chinese economy is hampering their ability to offer sufficient accommodation. Historically, China stimulus increases euro area exports with a 12-month lag, so without ample Chinese accommodation today, the outlook for year-ahead euro area growth is challenged.
Yield ideas for a lower for even longer interest rate environment
Given this challenged euro area outlook and the limited monetary policy toolkit, the ECB’s actions make a bit more sense, and a lower for (even) longer interest rate environment is logical. With that, we are revising our year-end 2019 rates outlook for the euro area. We now see 3-month Euribor at -0.30% and 10-year Bunds 0.25% at year-end (+/- 25 basis points), down from -.20% and .75%, respectively.
In our view, investors looking for a “better entry point” into euro area fixed income markets are likely to be waiting for some time. In search of a positive real yield in Europe, investors may consider either extending duration or adding credit risk. Here are a few areas to find yield:
EXTEND DURATION. Interest rate risk is not the enemy it once was, so we feel comfortable in adding longer maturity bonds via high-quality names. Furthermore, investment grade yield curves are still relatively steep globally, resulting in incrementally more yield for longer maturities.
ADD CREDIT RISK. There are a number of ways to add credit risk:
Bank debt. European bank tier 1 capital ratios have nearly doubled since the crisis—rising from ~8% to over 14%. The strong capital position provides the financial sector with excellent resiliency to external shock, and we view highly regulated global banks akin to utility businesses, yet their subordinated debt issuance trades at a significant discount to similarly rated corporate debt. For clients who want to escape negative deposit rates and seek to achieve a positive yield without interest rate duration risk, Euro floating rate notes are an option. However, be mindful of credit duration risk.
High-quality subordinated insurance debt and hybrid structures. The differential between high-grade issuer’s hybrid debt and senior debt widened significantly through 2018. While the market has retraced some of the move, there is still an attractive pickup, giving clients high-yield-like returns from high-grade issuers.
Select extended credit. The year-to-date rally in extended credit has been a global phenomenon—e.g., European high yield credit spreads are at about 500 basis points (bps), about 75bps tighter year-to-date, and are below the post-crisis average. In this pursuit of yield, the name of the game is selectivity. Considering we are in a low-growth, late-cycle environment, active management is prudent. After all, in our view, volatility may be higher than in recent years.
For more information about markets and whether these investment opportunities may be right for you, speak with your J.P. Morgan Advisor.
All companies referenced are shown for illustrative purposes only, and are not intended as a recommendation or endorsement by J.P. Morgan in this context.
The information presented is not intended to be making value judgments on the preferred outcome of any government decision.
All market and economic data as of April 2, 2019, and sourced from Bloomberg and FactSet unless otherwise stated.