Tanguy Le Saout, head of European fixed income at Pioneer Investments,answers questions on the ECB's forward guidance announcement.
Tanguy Le Saout, head of European fixed income at Pioneer Investments,answers questions on the ECB’s forward guidance announcement.
What’s your assessment of the latest European Central Bank’s board statement?
Key rates were left unchanged but leading central banks are proving able to shift investor expectations nonetheless. The European Central Bank (“ECB”) surprised investors on 4 July with a “forward guidance” on rates. The pledge that “monetary policy stance will remain accommodative for as long as necessary” aimed to allay investor concerns over the “tapering” of US quantitative easing and closely resembles a communication strategy long adopted by US Federal Reserve. Also remarkable is the emphasis on the “recent tightening of global money and financial market conditions” which “may have the potential to negatively affect economic conditions”.
Some investors greeted this forward guidance. Are they right to be confident?
Equity markets (and some risky assets) welcomed the guidance. The reaction may smack of irrational exuberance but looks also the mirror image of what happened at the end of June, after the US Federal Reserve (the “Fed”) released the time-table for tapering off quantitative easing (QE).
We thought investors were concerned about how fast the Fed would proceed on the way to policy normalization, and we argued that other central banks in developed countries wouldn’t be compelled to follow the Fed’s new course.
The Bank of England (“BOE”), under the new governor (former Head of Canada’s central bank) sent a similar and near-simultaneous message, as if the two leading European central banks acted jointly to reiterate their commitment towards loose policies. Leaving policies of economic stimulus aside and follow the Fed’s footsteps wouldn’t be recommended, with most European economies in recession or stagnating with lending rates still divergent among the core and peripheral countries.
Does this guidance mean the economic recovery is further postponed in Europe?
As equity prices rallied, both the Euro and the UK Pound lost sharply to the US dollar after the ECB and the BOE released their forward guidance. Such a commitment to zero-rate policies was unexpected from the ECB, which has often sounded relatively upbeat on the Eurozone’s economic outlook.
This pledge is unlikely to translate into actual moves, as policy rates are already close to zero with limited downside.
We see this move as an attempt to disconnect the Euro and the US curves, after we saw the sell-off in US Treasuries contaminating most Euromarkets.
So is monetary expansion still needed to offset fiscal austerity?
In fact fiscal policies may become slightly looser (or, rather, less tight) amid evidence that a combination of higher taxes and spending cuts has deepened the recession and brought structural deficit down.
In this “austerity fatigue” climate, a relaxation of fiscal targets is underway and financial markets do not seem to disapprove of that. This change of mind was even inspired by the International Monetary Fund (IMF), whose chief economist last year conceded that tight budget policies long imposed (also by the IMF) to high-deficit countries may bring more damages to the economy than previously thought, while the benefits of structural reforms may be eventually enjoyed in the very long term. Portugal is probably the most telling example, as it tried hard to meet all fiscal targets with few concerns about their recessionary impact.
Is Portugal’s crisis reviving the Euro crisis?
Portugal’s woes are unlikely to be contagious. The deteriorating domestic political climate was the trigger. Two high-profile government members resigned in a matter of days. The man in charge of economic policy was the first to quit but the second resignation was more worrying for political reasons, as the foreign minister is the leader of a party holding the balance in the governing coalition, which would lose the parliamentary majority if it pulled out and lead the country into early elections.
However, we believe this setback will not affect the group of creditors’ mission in the middle of July. The “Troika” comprising the European Union, the International Monetary Fund and the ECB is set to release another review of Portugal’s economy. We expect it to give good grades despite all the current difficulties and that may lead to softer terms on existing loans released under the bail-out plan two years ago.
So isn’t Portugal a catalyst for rising yields and spreads?
It’s the other way around in our view. There has been a more challenging climate since the US Federal Reserve’s supposed turn of policy, as investors appear to be less eager to buy high-yield bonds with few worries about the debtor’s credit standing. As a result spreads have risen almost everywhere in credit markets, both sovereign and corporate. Portugal’s country risk is up sharply from early May lows but only half the increase appears to be directly caused by domestic politics. Moreover, in the midst of the euro crisis Portugal’s troubles would have affected all peripheral bond markets, whereas Italian government bonds have been positively correlated with German of late.
How do you respond to this scenario?
We have become more cautious on EMU periphery markets as spreads declined, even more so as the US Federal Reserve plans to taper off its QE program. We are not arguing that the Fed’s (probably gradual) new course will undermine peripheral countries’ fundamentals, but we are mindful that some investors would be less hungry for yields and credit markets would suffer somewhat under the new scenario.
Europe’s central banks “forward guidance” seems to be welcomed so far as it reassured investors that the needed stimulus for struggling economies will not be withdrawn. With this verbal commitment, both the ECB and the Bank of England have sanctioned the different economic performance and outlook on the two sides of the Atlantic. However, we also believe there is another side to this new approach. The pledge to keep low interest rates may prompt expectations of quick policy action, both on rates (which have little downside nonetheless from near-zero levels) and other, lessconventional measures that the ECB may find it hard to adopt.
The to-do-list is pretty demanding, from a negative deposit rate for banks holding excess reserve at the ECB to country-specific schemes to help overcome the bank credit crunch, which the ECB blames as a stumbling block toward the recovery. Another short- term stimulus may be provided by a weaker euro, which it is close to historical average in trade-weighted terms. Talking the Euro down is not, however, among the prerogatives of the ECB.
What is the likely scenario on Europe and your line of action looking ahead?
We still believe that the economic recovery could be on track for the second half of 2013. Admittedly this is a further postponement from recent consensus forecasts, what makes a real improvement in peripheral countries’ government finances pretty unlikely any time soon with the risk of further debt downgrades. Italy’s was a case in point, showing how long it takes for real economic reforms to be achieved. The rating agency also pointed to the impaired monetary transmission mechanism as a stumbling block, what brings us to the banking sector’s fragmentation so often evoked by the ECB.
In this uneasy environment we will duly be looking at international fixed-income flows before making any decisions on our credit and peripheral exposure.
We expect our European fixed income investment strategies based on individual selection (also known as “alpha-based”), which aim to deliver positive uncorrelated performance, should continue to perform.
This uneasy environment strengthens the case, in our view, for investment strategies based on individual selection (also known as “alpha-based”), which in fixed-income portfolios are less likely to be affected by the trend of global bond markets (so-called “beta” factor). We believe that achieving this goal is especially important when the global trend may be negative.