3 Things the European Investment Grade Fixed Income Team Talked About Last Week

Did Brexit Really Happen – Part Deux?

Last week we posed the question as to whether Brexit had really happened, given the performance of the UK stock markets and bond markets. The “Brexit – what Brexit?” cheerleaders were in full cry at the start of last week with the publication of the Euro-area Purchasing Managers Index (PMI) for August. Despite concerns that the UK vote would have a knock-on effect on European economic activity and sentiment, the Euro-area Composite PMI (a combination of the Services and Manufacturing PMI’s) showed little change in activity. The level for August printed at 53.3, slightly higher than the July level of 53.2 and ahead of consensus forecasts of 53.1. The Services component increased by 0.2 to 53.1, whilst the Manufacturing component showed a minor fall from 52.0 to 51.8. It appears that the improvement in the Services component was driven by better performance from France and peripheral Europe, whilst the decline in the Manufacturing component was affected by a more broad-based easing of momentum, but led by Germany. Admittedly, drilling down deeper into the sub-components could suggest that the outlook in coming months might be tilted towards the downside (services business expectations fell 0.7 points). But right now, the signal from the Euro-area PMI’s suggests that growth is holding steady in Q3 and that quarterly growth in the region could match the first quarter’s level of 0.4% quarter-on-quarter, or about 1.6% annualised. That would certainly please the ECB ahead of their meeting on September 8 ^th , where the ECB could be under pressure to clarify the expected end date of their bond-buying programme, currently due to expire in March 2017. But that wasn’t the end of the story – there was a bit of a sting in the tail.

German Data Disappoints

The PMI data had already signalled that German economic activity might just be cooling a bit, albeit from quite strong levels. The August Composite PMI printed at 54.4, down considerably from last month’s 55.3. This decline was primarily driven by the Services PMI which fell from 54.4 in July to 53.3 in August, whilst the Manufacturing PMI dropped slightly from 53.8 to 53.6. Interestingly, on the manufacturing side, demand for new orders weakened significantly, but manufacturing new export orders rose again, having dipped in July. This suggests that the initial pessimism about the UK vote is not yet being reflected in orders. Then the German Statistics Office reported last Wednesday that the budget (which has been in surplus since 2014) increased between January 2016 and June 2016 to €18.5bn, or 1.2% of Gross Domestic Product. This is a record surplus, made possible by rising tax revenues as the economy continues to grow and debt costs falling to record lows, courtesy of the extremely low levels of interest rates and bond yields. Finally, we got a triple blow last Thursday with three different business confidence surveys across Europe being released and all three falling. French business confidence fell from 102 to 101, Belgian business confidence posted its largest monthly drop in 5 years, falling 4.1 points to -3.1, whilst the German IFO business climate index dropped from 108.3 in July to 106.2 in August. This was the biggest monthly fall since February 2016, and the second-biggest drop since June 2012. It might seem obvious that Germany has plenty of capacity to increase investment, especially as there have been complaints recently about the lack of new investment in an ageing economy. The details of Germany’s Q2 GDP number certainly highlighted that sharp decline in investment. Unfortunately Chancellor Merkel’s coalition cannot agree on what to do with the budget surplus. In the meantime, the three business confidence surveys were a reminder that it might be too early to sound the “all-clear” on the economic effects of Brexit.

Spanish Revenge

In the last 16 of the recent Euro 2016 football championships, Italy gained revenge for a 4-0 drubbing in the Euro 2012 final by beating Spain 2-0. Tipped as one of the pre-tournament favourites, Spain’s exit prompted the departure of their coach Vicente Del Bosque and led to concerns that it might have been the end of a golden era for Spanish football that saw them win Euro 2008, the World Cup in 2010 and the Euro championships again in 2012. However, Spain’s footballing woes are being offset by a stellar out-performance in European bond markets. Having traded as high as 20bps above similar-duration Italian sovereign bonds at end-March 2016, Spanish 10-year government bonds now yield over 20bps lower than their Italian sovereign counter-parts. Why has this happened? We think there are a couple of reasons – firstly, the Spanish economy is experiencing relatively rapid growth. Q2 GDP was revised higher to 0.83% quarter on quarter, suggesting that an annualised growth rate of 3% is on the cards for 2016. That would make Spain the 3 ^rd fastest growing region in the Eurozone after Ireland and Slovakia. Secondly, Spain has made much better progress in consolidating and recapitalising its banking industry than Italy. Thirdly, Spanish banks were large sellers of Spanish government bonds in 2015 in order to reduce their large existing exposure, whilst Italian banks did not undertake the same action with respect to their holdings of Italian government bonds. But since the start of 2016, Italian banks have been buying non-domestic Eurozone sovereign paper, and especially Spanish government bonds. Finally, the political situation had been looking a bit clearer in Spain, with the incumbent PP party accepting the conditions set out by a smaller party (Ciudadanos) for forming a coalition. That coalition would still fall short of an overall majority but a minority government could potentially be formed, ruling out the possibility of a third election within 12 months. Y Viva Espana.