Investors have rightly been concerned about the coordinated global economic slowdown, but in Europe it has been worse than that with the major economies flirting with recession. Consequently investors have been cautious on European assets, but has this caution now reached its peak?
Germany and France account for roughly half of the Eurozone GDP, and they have very different economies, but both have had their own specific issues causing growth to stutter. In Germany the economy is very much production focussed, with a strong contribution from the automotive sector in particular, and this sector had specific issues in the second half of 2018 which weighed heavily on output. The pharma sector, which is not of the same importance, had a major revision in Q4 which resulted in almost as much damage to GDP as the auto drop. Additionally the US trade war with China and the ongoing Brexit uncertainty have contributed to the less favourable environment. These specific drivers though should diminish somewhat as 2019 progresses. However ,there is a risk that President Trump could impose auto tariffs on the Eurozone; the question is whether he will want to plunge straight into another dispute just as an agreement with China seems to be within reach?
In France the economy is much more consumer driven and sentiment for both the consumer and small businesses has been adversely affected by the aggressive protesting of the yellow vests. While the issues that the protestors are complaining about have not gone away, their impact on the economy has possibly reached its peak.
It is hard to talk about the Eurozone economy without mentioning Italy, which for many investors may be the biggest of their concerns. It is also Europe’s weakest economy and the initial impact of the populist coalition that governs the country was a 250bps tightening of financial conditions (the yield on their BTPs). Essentially this was equivalent to the 3 years of tightening that the Fed has deployed on the US economy, however this was on Europe’s weakest economy. It is fairly clear why growth is negative. Once again though, the largest impact of this tightening might be behind us with BTP yields having peaked in October last year, and since then they have rallied by around 100bps at the 10 year point. This is still far from ideal, but better than at its worst.
So in summary, all three of the Eurozone’s largest economies have had, and are still having, quite specific issues but these issues may well be wearing off as drivers of sentiment.
This brings me on to the ECB who have their governing council meeting in Frankfurt tomorrow. We expect a dovish tone to emerge and at the least they will have discussed the possibility of a replacement TLTRO for the banking system. Even if it’s not announced tomorrow, it will be the first question in the press meeting afterwards and I doubt Draghi will say that they did not discuss such a key topic. Furthermore, we think the weaker banks in Europe need a last chance to gorge on free money. The stack of NPLs across Europe’s banks is shrinking as loans gradually perform once again, or are sold off or defaulted and to some extent recovered. However the stack of loans is still large in some jurisdictions with the smaller banks who have not been capable of recovering as quickly. These banks simply need more time before their stack of NPLs become negative carry NPLs and a last TLTRO is a very practical solution, which is why we think that at some point the ECB will announce a new facility. Another reason why sentiment may be bottoming out.
Lastly, and one for the bears, even if none of this is true, and Europe plunges closer and closer to recession, we don’t think a recession in Europe is as important as a recession in the US from a fixed income standpoint. The reason is that a recession in the US will be more likely to trigger a default cycle than a recession in Europe. Corporate leveraging has been more aggressive in the US than in Europe and on top of this official rates have risen 9 times. If the US commercial banks now tighten lending standards on top of the central bank tightening, the interest coverage ratios will weaken further so then at the point of recession, when net income drops, we are more likely to see defaults. I would stress that interest coverage still looks robust in the US but the direction of travel could be weaker. In Europe that corporate leveraging has been less aggressive and rates have not changed, meaning the default cycle would be a lot less severe.
So from a fixed income point of view, we believe that holding European credit now while it is priced so much cheaper than the US does not actually feel so bad. We would still caution though that exposures should be kept relatively short to reduce late cycle volatility.