Yet more acronyms!

The European economy has hit a soft patch. July Euro-zone retail sales were uninspiring with notable weakness in Germany. The most recent PMIs are off their peaks. Inflation prints continue to trend lower. The ECB itself has recognised that real growth prospects for 2014 and 2015 need to be revised down, albeit modestly. This is partly self-inflicted.

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The European economy has hit a soft patch. July Euro-zone retail sales were uninspiring with notable weakness in Germany. The most recent PMIs are off their peaks. Inflation prints continue to trend lower. The ECB itself has recognised that real growth prospects for 2014 and 2015 need to be revised down, albeit modestly. This is partly self-inflicted.

By Henrietta Pacquement

The European economy has hit a soft patch. July Euro-zone retail sales were uninspiring with notable weakness in Germany. The most recent PMIs are off their peaks. Inflation prints continue to trend lower. The ECB itself has recognised that real growth prospects for 2014 and 2015 need to be revised down, albeit modestly. This is partly self-inflicted.

Some European countries, namely Italy and France, are behind in terms of structural reform and this is starting to show in their relative economic performance. Renzi is tackling reforms in Italy. Valls may provide a clearer, more business friendly vision in France. But more is required. It is also driven by external events with the increase in geopolitical risk, particularly around the fluctuating situation in Ukraine. This has hit business and consumer confidence. As a result, market participants were looking for a strong signal from Draghi last Thursday and they got one as well as two new acronyms ABSPP and CBPP3.

On balance, the rate cut was a bit of a surprise given Draghi’s ‘lower bound’ comments on rates before the summer. But this is supportive of what Europe is looking to do regarding the EUR: engineer a continued decline against major currencies. In addition, while the Fed has been growing its balance sheet over the last few months, reaching well over USD4trn, the ECB has been shrinking theirs. This trend is now set to turn with Draghi hinting the ECB’s balance sheet size may return to 2012 levels implying an increase of up to EUR1trn from current levels. The aim of the combined tools, be it the TLTROs or the announced ABS Purchase Programme (ABSPP) and the third Covered Bond Purchase Programmes (CBPP3) (the two new acronyms) is to feed funding into the real economy and continue to reduce financial fragmentation between core and periphery.

The ECB is hoping to free up space on bank balance sheets so that the financial system can continue improving its fundamentals while at the same time ease credit conditions for households and non-financial corporates. Last Thursday’s extension of the purchase programme to covered bonds and RMBS is to ensure there are enough assets to purchase to make a difference. SME securitisations totalling just over EUR100bn were not going to make enough of an impact. For now however, the ECB has stopped short of buying government bonds, the largest pool of tradeable debt in Europe and a significant allocation in peripheral bank balance sheets particularly in Spain and Italy where exposure to sovereign bonds averages some 10% of total assets.

These moves show the degree of ECB concern over slowing inflation in Europe. Addressing this trend is well within the ECB’s mandate and this gives Draghi a bit more freedom to act. There was some dissent regarding the measures announced and there is possible market scepticism on how much take up the TLTROs may have and what volume of assets the ECB may end up being able to purchase. However, these packages do amount to significant potential easing in the financial sector. The Purchase Programmes (PPs) in particular address one of the shortcomings of the TLTROs: the issue for banks is not necessarily funding at the moment, but balance sheet capacity.

We expect this to translate into lowered public issuance volumes of European covered bonds and senior financials. Issuance of subordinated financials will likely continue apace as capital ratios continue to be improved and regulatory requirements filled. The AT1 market has already kicked off Michaelmas term with bluster. Disintermediation is also likely to continue in high yield and the loans market. Pressure to issue in the investment grade corporate space may stay lower as economic conditions in Europe do not warrant significant increases in capex and corporates remain defensive regarding their balance sheets. All in all, the ECB actions last Thursday remain supportive for credit.

 

Henrietta Pacquement is lead portfolio manager & head of quantitative analytics at ECM Asset Management

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