Elements of stress in Europe’s bond markets mean investors should be selective, says Pioneer’s Tanguy Le Saout

Tanguy Le Saout, head of European Fixed Income at Pioneer Investments, sees a mixed picture for European bonds, with volatility and political risk still stalking the markets.

Over the last days, volatility is back in the European Fixed Income markets, with peripheral spreads on the rise again after a decline over the past six months. Do you think this implies a return to structural stress in the market or is it just a temporary effect?

In our opinion the major risk right now for peripheral countries is political. We believe that the current increase in peripheral spreads is temporary and that the trend towards a normalization of financial conditions and structural reforms in the peripheral countries is set to continue in 2013.

Spreads have tightened since the latest ECB bond-buying plan was announced, notably for Italy and Spain. Can this be attributed to the efforts of the ECB or do some governments deserve credit for pursuing much needed policies?

The Outright Monetary Transactions (OMT) plan need not even have been activated by the ECB and that’s a measure of how credible its action was. For being conditional to a request for financial assistance, it should remain sort of a “nuclear deterrent” to show its effectiveness.

For their part, countries that have embarked upon tight budget policies and deep reforms have definitely had a part in changing market expectations, although there is still plenty of work that needs to be done.

Do you see any risk of complacency in countries which have pursued austerity and reformed policies which have helped shift investors’ expectations?

We acknowledge that some good work has been done but efforts will have to continue. This applies not only in peripheral countries hard-hit by the crisis but also in countries like France, where reforms should focus on improving its international competitiveness. The risk of complacency exists in financial markets despite the wave of confidence registered since last summer should continute to act as a reminder to governments that they should not back track..

Spain will remain under close watch in our view. We believe that the Spanish government will have to cut its budget deficit to avoid another debt downgrade, that could trigger a further bout of volatility in bond markets.

Do you believe that capital flows will continue to go back to peripheral countries, as indicated by recent data?

The return of over €100bn to peripheral EMU countries is consistent with the global search for yield, which in turn has been prompted by Central Banks’ expansionary policies. Not only domestic but also international investors are coming back to the European fixed income markets, having missed most of last year’s rally. We have seen a lagging effect of past performance on flows many times over indeed, but the low expected returns on core bonds could make this search for yield sustainable in the coming months.

This new climate and the perception of a “back-to-normal” situation, however, is not a reason for political leaders to relax for too long or slow down the reform process, as these commitments are necessary to avoid a return of instability in the markets.

Have we got any closer to pre-crisis levels in terms of liquidity and capital flows, or are conditions still far from (the old) normal?

There is evidence of a return to normality on several counts. The ECB balance sheet shrank to the smallest in almost one year, while it seems that other major central banks are not winding down the assets built up as a result of QE-like policies. Another key development is a lesser reliance on ECB funding and the resumption of a properly functioning interbank market. The improved confidence resulted in the decision by some banks to redeem the funds borrowed from the ECB with the two big LTRO operations earlier. We believe that this could restore normal liquidity conditions in the money market and therefore eventually trigger a convergence of EONIA rate (now below 0.10%) towards the ECB reference rate (now at 0.75%), but there is a long way to go as excess liquidity is aplenty. This should not be seen as a symptom of malaise but of a more regular financial framework, with no detriment for the real economy.

This recent evolution seems to mark a “natural” exit strategy from unconventional policies. However, it does not mean that the ECB is making plans to terminate the easing stance, also because credit conditions based on freshly released ECB figures remained quite tight for the private sector in December, despite some fledgling improvements. The latest trends in currency markets may also be against an early normalization of policy, as we look into more detail below. I believe that the ECB may keep a much lower profile this year, but will stay on watch and be well aware of the many risks still looming.

The broad credit market continues to trade briskly, with most new issues quickly bought up by yield-hungry investors. Are valuations still attractive?

Companies are eager to get cheap funding now that risk aversion is receding. As long as their policies remain conservative, also on cost cutting, there should be little or no concerns about excess leverage and debt downgrades. Declining credit spreads make for less compelling opportunities, but valuations remain overall attractive, also in the banking sector, that has benefited the most from ECB measures.

What could be the implication for the recent euro currency appreciation?

The stronger euro is first a consequence of foreign investors’ renewed confidence in the euro-zone. However, we do not believe that a 5% appreciation in the euro’s trade-weighted value reflects a stronger Eurozone economy at this stage. We should acknowledge that the euro strengthened sharply because of extremely loose monetary policies in the US and Japan, whereas the ECB is expected to wind down its own unconventional measures. The ECB hardly wants to see a further acceleration of this trend. A stronger euro could negatively impact the countries with weak domestic demand relying on external sector for growth, jeopardising the recovery. On the other side, reducing the cost of imported goods, such as oil, a stronger euro can help keeping inflation under control. In this sense, I believe that it could be an overall positive scenario for the European Fixed income sector.

What are the main risks and opportunities for investors in European Fixed Income in 2013?

Investors may be getting less used to volatility and be surprised at some unexpected events. Fears of a sharp rise in core bond yields, reducing the premium enjoyed by most credit markets, may keep investors on the edge, but a replica of past bear markets is unlikely, as inflation stays under control. Even if the yield curve shifted up, signalling an overdue normalisation of financial conditions, the impact could be more on the short -term maturity, while the longer end of the curve should be less affected.

As elections approach in Italy and Germany, policy mistakes are another possible trouble spot, in terms of opportunities, I still see some value in both the EMU periphery (notably on Italian and Spanish government bonds, despite recent spreads tightening) and in the corporate sector. The interest-rate risk is usually minor in credit markets, due to a shorter average duration, so that they should be partly shielded from sharply falling prices in benchmark markets. That said, we also think that the global search for yield will continue for a while, providing a strong bid for credit markets and leading to further spread compression. However we recommend a selective approach going forward, which is crucial to finding the value still available in the asset class.


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