By David Zahn
The contrast between the UK and eurozone economies grew over 2014, with the UK’s second-quarter 0.9% expansion at odds with a slowdown in Germany, stagnation in France and recession in Italy. This begs the questions: why has the UK’s recovery been so much stronger and what challenges remain for both going forward?
The UK has been a single market for much longer and, while the Bank of England (BoE) is the second oldest central bank in the world, the European Central Bank (ECB) was only formed in 1998. Consequently, the eurozone is still consolidating and grappling with differing growth and unemployment rates and debt levels.
The eurozone is not a true economic union. Though the ECB sets interest rates, individual governments make their own fiscal policy decisions and issue their own debt, hence the periodic widening of spreads between bonds of member countries during times of concern about the creditworthiness of individual countries. This is not a failing of the ECB, but indicative of a lack of consideration about the disparity of debt levels and growth rates when the euro was created, and the rapid expansion of the single currency market did not allow sufficient time for consolidation.
Although the UK government was quicker that many of its eurozone counterparts in its response to the financial crisis, especially in areas like bank restructuring and austerity measures, the effectiveness of such policies has been questioned as levels of debt in UK have remained broadly unchanged. Moreover, data has indicated a largely domestic, consumer-led recovery, with many UK exporters still struggling, which is surprising as wage inflation has remained stubbornly low.
The UK faces more challenges ahead to maintain growth levels. Austerity policies have limited public sector wage growth to 1%, while fragile growth in the eurozone will continue to hinder the UK’s already struggling export sector.
The eurozone continues to encounter challenges, given the problems faced, not only by the periphery countries, but also within the soft core countries. The ECB is under growing pressure to act, but remains reluctant to implement outright quantitative easing (QE), because some policymakers within the eurozone continue to perceive it as unnecessary.
Part of the reason for the ECB’s hesitation on QE may be a wish to gauge the effectiveness of its TLTRO (Targeted Longer-Term Refinancing Operation) programme. The ECB believes individual governments should be doing more to reform their economies, most recently identifying France and Italy and suggesting that QE would have no effect unless existing barriers to business are lifted. If economic data across the region remains weak, as seems likely, we anticipate outright QE could be introduced early in 2015.
The eurozone is some way from a sustained recovery and could be a region of slow growth for some time to come. Whilst the UK could be the first G7 country to raise interest rates, such rate rises in Europe seem some way off, as reflected by euro and UK yield curves.
This slow growth, low interest-rate environment is one in which European fixed income should perform relatively well. However, we would be cautious about UK gilts outside of the very short end of the curve, preferring to take exposure to the UK through select corporate bonds from issuers that are well capitalised and positioned to benefit from a recovering UK consumer. The eurozone, in contrast, is a region where we would be comfortable in holding longer dated debt, given the expectations that interest rates are not going to rise there for some time.
David Zahn is head of European fixed income at Franklin Templeton Fixed Income Group
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