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Cyclical vs Structural

19 May 2017 by Felipe Villarroel

A couple of weeks ago we received the always eagerly awaited Purchasing Managers’ Index (PMI) Reports, which included the final numbers for the month of April. The Eurozone continues to show very strong figures with a virtually straight upward sloping line from 51.7 in August 2016 to 56.7 in April 2017. Not only has the move been quite steep, the absolute number is also the highest since 2011. The effects of this cyclical uptick have been very clear in spread performance, as an example, a good number of European High Yield issuers that were previously struggling are now showing much better results and prospects. Furthermore, the CCC part of the index has returned almost twice as much as the single B equivalent in 2017, according to the BAML indices. We suspect the stronger cyclical picture has had an impact in the retreat of political risks in the region; when economic conditions are improving there is less of an incentive for a protest vote, which makes the disruptors less likely to make their way into power. Markets have certainly cheered the results in the Dutch and French elections over the last few months, not surprisingly.

Although the aforementioned is certainly positive news, investors with a medium to longer term investment horizon should not forget that cyclical considerations are very different from structural ones. The Eurozone still faces structural challenges with low potential growth, adverse government debt dynamics in certain countries, an uneven banking system (with parts of the periphery, such as Portugal, where the impact of loose monetary policy is not felt as it should be), and still high levels of unemployment (particularly among the younger cluster of the population). Politics may have not caused mayhem so far this year, but the fact that populist candidates such as Marine Le Pen, Podemos and Geert Wilders have obtained their highest share of votes in years at a time when the cycle is actually very positive, makes us wonder what would have happened if these elections had taken place with PMIs in the mid to high 40s, as opposed to in the mid to high 50s. We should also not forget that tail events in the Eurozone might have a larger impact than in other geographies due to the possibility of a country exiting the Euro. The better cyclical environment definitely helps, as it buys time to carry out reforms to address these structural issues, but it does not cure them on its own.

For now we are happy with our selective allocation to Euro denominated assets, including cyclical parts of the market, however, we continue to keep a close eye on how the structural picture is evolving in the background.
With this in mind, we would still prefer to capture Brexit premium in the UK and the relative stability of the US, albeit at lower spreads.

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