Despite the many dire predictions of gloom and doom both before and immediately after voters in the U.K. approved Great Britain’s exit from the European Union (EU), data coming from Europe in the little more than three months since the June 23 vote suggest limited, if any, contagion to the Eurozone economy.
The fact of the matter is: Brexit has not been a major shock to the Eurozone’s confidence.
As we discussed at the time, we believed the key impact of Brexit would work through its effect on confidence, rather than on direct trade links. A limited effect on confidence would mean limited impact on the Eurozone outlook as well. To many, that didn’t appear likely in the wake of the Brexit aftershock.
Yet, the facts year to date are:
- Equity markets recovered from the initial shock of the Brexit vote.
- Sovereign borrowing rates remain at historic lows.
- There are no visible signs of financial stress in major peripheral economies, Spain and Italy.
- Lending rates to non-financial corporations declined significantly and converged across core and peripheral economies, an encouraging sign of monetary transmission.
Overall, financial conditions in the Eurozone are arguably looser now than before Brexit (Exhibit 1).
The rising trend line, which indicates a loosening of financial conditions, is positive for businesses and the Eurozone economy.
Eurozone Purchasing Manager Indexes (PMIs) were mildly weaker in August but remained stable in the three months following Brexit. The composite PMI ticked up from 53.1 in June to 53.2 in July, and the most recent flashpoint on September 23 was at 52.6, comfortably above the expansionary level of 50. In fact, the composite PMI has been quite stable, in the 52-55 range, since the beginning of 2015 (Exhibit 2).
This has delivered 1.5%-1.7% GDP growth momentum during this period (Exhibit 3).
While GDP tracking for the third quarter of 2016 is showing mixed evidence on growth momentum, this is within a range of typical volatility in the data and does not look like the weakness that might be expected following a major political shock the magnitude of Brexit.
Eurozone Economic Resilience
In our view, a key to the resilience of the Eurozone economy is that growth in recent quarters has been driven by domestic factors. Consumption growth is supported by healing labor markets and job creation that lead to income growth and improving consumer confidence. Capital expenditures are not strong but have begun to pick up and add to growth. Credit markets are reopening after years of financial sector clean up and deleveraging.
Importantly, fiscal policy, which was a significant headwind before 2014, became a tailwind over the past two years and added to growth. Fiscal policy should continue to add to growth next year, given elections in France and Germany and very low borrowing rates that deliver savings.
We think these trends will continue to deliver stable growth. While some headline risks certainly exist, such as Italy’s pending constitutional reform referendum, we note that the Eurozone has been stress tested for such risks in the past few years as a result of the Greek and Ukraine crises, the banking sector crisis, China led volatility and Brexit most recently.
What to Look for From the ECB
Against this backdrop, we believe the European Central Bank (ECB) is not done with monetary easing, as Europe’s inflation outlook is not promising. In its last meeting, the ECB did not change its policy, which some market participants may have read as hawkish.
The ECB’s own inflation forecast for 2018 is 1.6%, significantly below its target of about 2%, and as the bank itself admits, the risks to the economy are to the downside. As illustrated below, there simply is no upward momentum in Eurozone core inflation as shown in the ECB’s Harmonised Index of Consumer Prices (HICP) (Exhibit 4).
Looking forward, inflationary pressures are limited. Labor markets are improving but there is still excess capacity in the economy, which means no significant wage and inflationary pressures exist. While the private sector managed to lower its debt ratios, and the worst may be over on that front, the Eurozone still needs nominal GDP growth to make further progress in deleveraging.
Meanwhile government debt ratios have worsened since the 2008 financial crisis. In the absence of major structural reforms or much stronger fiscal stimulus, the ECB is still the only play in town.
We believe the ECB will extend its quantitative easing purchases beyond March 2017, possibly to the end of 2017. This may be announced in December at the same time the ECB’s 2019 economic projections are revealed. We don’t expect further rate cuts.
In his press conference following the ECB’s September meeting, ECB President Mario Draghi said that relevant committees were assigned to evaluate the bank’s asset purchase programs with a mandate to provide policy options, so as to ensure smooth implementation of the program. This is aimed at addressing the “asset shortage problem”: some EU countries have less debt and lower deficits than others, while purchases are proportional to each country’s contributions to ECB capital. It is likely that limited deviations from the capital key would be allowed.
Our portfolio favors European credit, both investment grade and high yield that should continue to benefit from ECB easing in both the rate and credit spaces. Stabilization in growth and inflation, with continued deleveraging, should, in our opinion, continue to provide a favorable backdrop for credit.
The implications for the Euro are mixed and dependent to some extent on Federal Reserve policy. Our current position reflects this neutral bias.
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Fixed income investing entails credit and interest rate risks. Below-investment-grade (“high yield” or “junk”) bonds are more at risk of default and are subject to liquidity risk. Foreign investments may be volatile and involve additional expenses and special risks, including currency fluctuations, foreign taxes, regulatory and geopolitical risks. Emerging and developing market investments may be especially volatile. Eurozone investments may be subject to volatility and liquidity issues. Diversification does not guarantee profit or protect against loss.
These views represent the opinions of Portfolio Managers at OppenheimerFunds and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the publication date, and are subject to change based on subsequent developments.