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Our views 26 July 2021

JP’s Journal: Strength in identity at the ECB

5 min read

I think we are in for some tougher times in EU:UK relations. Last week, after growing frustration with its impact on trade between the UK and Northern Ireland, the UK government sought changes to the Brexit deal – I don’t think the EU will budge.

I can only see things getting worse from here, and I see the politics of this moving the UK to invoke Article 16 whereby the UK unilaterally suspends the agreement. Admittedly, politics dominated the impetus to get a deal done in the first place, but the naivety shown by the UK in signing the agreement is surprising.

Of course, not all is rosy in the EU either. Covid initially led to a fragmented response by nation states and there are clear tensions between newer members and the more established core. In addition, there is the slow leaking of economic clout made worse by adverse demographic trends. Above all, there remains a doubt whether the EU is flexible enough to cope with shifting trends. Big is not always beautiful.

One EU institution, however, has clearly established itself and that is the European Central Bank (ECB). An underappreciated aspect is how the ECB has created its own identity rather than being seen as adjunct to the Bundesbank. Under Draghi, and now Lagarde, the ECB has had strong leadership which has helped to establish creditability with investors. So, on Thursday, when the ECB gave its latest update, markets took notice. In essence, the ECB committed to remain accommodative for longer, pledging not to raise rates unless inflation is above the 2% target over two-year horizon. What this means is that they are happy for inflation to go beyond 2% if it is believed that, in the medium term, it will come down again.

We can’t see Euro rates rising for at least two years and think that the messaging supports continued yield spread compression within Euro government bond markets. This is great news for Italy, for example, where 10-year borrowing costs have collapsed over the last 25 years, going from 10% to 0.7%. Our funds are positioned for outperformance of the ‘semi’ area, those that offer a spread premium to German bonds, so we are happy with developments here. We also continue to like inflation protection in the Euro market, not because we see a surge in inflation but because it is cheap insurance – certainly compared with the price of UK inflation-linked bonds. The ability to trade between UK and Euro markets, on a hedged basis, has certainly been beneficial for our strategies.

Cash and government bonds

Global PMIs are consistent with slower growth in July, with the US composite PMI falling from 63.7 to 59.7. It looks likely that supply chain issues and bottlenecks were an issue with services firms, linking weaker growth to labour and stock shortages. The new business indicator also slowed, reflecting cost pressures and higher selling prices; the survey indicated positive but slower jobs growth and a fall in business optimism.

European data was more upbeat with the Euro area composite PMI rising from 59.5 to 60.0, a 21-year high, driven by services, while manufacturing dipped slightly due to supply chain problems. In the UK, despite further reopening, the composite PMI fell from 62.2 to 57.7 with respondents citing raw materials shortages and Covid-related staff shortages. In addition, the UK PMI also showed a decline in the new orders indicator – some firms cited a drop in customer confidence due to the resurgence of Covid-19, whilst others reported continued Brexit-related difficulties with exports.

Government bond yields continued to reflect some concern about future growth prospects, with US 10-year treasury yields ending the week at around 1.25%. Yields fluctuated in the UK but settled below 0.6%. Breakeven inflation rates were more stable, although there was an increase at the longer end of the UK curve.

Sterling weakened a touch against the USD, whilst cash rates were broadly unchanged.

Credit

Investment grade spreads tended to widen over the week, however the impact was marginal, and valuations remain pretty close to the lows of the year seen in June. New issuance remains relatively strong for summer months with borrowers eyeing favourable all-costs. We continue to see issuance in the Social Housing sector, but the long maturity of many of these issues makes them less attractive from our viewpoint.

In high yield, spreads also moved higher with the yield premium moving back to May levels. Issuance again remains strong, but we are finding fewer opportunities that really stand out.

AOB

It was great to see the British & Irish Lions fight back on Saturday, and also, on a more parochial note, Royal London’s support for the sport. Let’s keep fingers crossed for next Saturday.

 

Past performance is not a reliable indicator of future results. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are the author’s own and do not constitute investment advice.