Euro fixed income investors face bumpy ride

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The pressure on policymakers in Europe is unrelenting. Weak confidence, growth, inflation and employment means governments don’t have a lot of flexibility over public finances, while the rising influence of new political parties and independence movements is increasing the pressure on the state to make money more freely-available. After several years of austerity in Europe without very much to show for it, it is not hard to imagine that tax collection, spending discipline and willingness to service debts could all start to suffer in the future.

Rising political and economic uncertainty suggest caution is warranted. Bad times mean bad choices will be made by everyone, so the key for politicians – and fund managers – will be to try and make as few bad choices as possible. This reality, coupled with low interest rates and an unrelenting search for yield among end-clients, suggests individual stock selection will be key to outperforming in bond markets in 2015.

The EC released its Autumn macro forecasts in November 2014 and – compared to its previous Spring forecast – it has revised down its outlook for growth and inflation over 2014-15, and revised up its forecasts for the Euro Area fiscal deficit. The EC’s forecasts are slow to change, but illustrate nicely the stress points in the next couple of years.

It is clear from the data that on average creditworthiness in the eurozone – as measured by debt/GDP – continues to deteriorate, and that some countries are doing much better than others. According to the EC’s data, of the 11 largest countries in the Euro Area, only two experienced a reduction in their debt/GDP ratio in 2014 (Germany and Ireland) and only two kept the ratio stable (Portugal and Greece), while the other seven all saw a further deterioration in the ratio. Obviously, this trend in debt/GDP can’t go on forever.

The EC is projecting that the average debt-to-GDP ratio in the Euro Area won’t get worse over the next two years which – looking at the other variables the EC forecasts – assumes the Area’s average GDP growth rate doubles, the average inflation rate triples and the average fiscal deficit shrinks by 20% relative to GDP.

What this implies, of course, is that if prices, output growth and fiscal prudence don’t improve materially over the next two years, the average debt-to-GDP ratio in the Eurozone could go up a lot. This in turn would imply that the dispersion between each country’s debt-to-GDP ratios would also be likely to go up, and this in turn could cause more dispersion in sovereign bond pricing and more market or economic volatility.

So the big question is: what evidence do we see that a trend improvement in eurozone growth, inflation and fiscal deficits is about to start? The eurozone should benefit from cheaper oil and a cheaper Euro, but they are the only bright lights. Growth in emerging markets, Japan and Germany seems to be slowing, which will hurt growth and trade prospects for the eurozone as a whole.

Also, alternative political parties are growing in popularity and influence in Europe, and this is likely to diminish support for fiscal reform and austerity. Europe’s traditional politicians have a lot of work to do first to regain trust and engagement if they are going to have any chance of sorting out the region’s problems.

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