Q&A: Europe's getting s-l-o-w-l-y better
We recently asked Ihab Salib, senior portfolio manager and head of Federated’s international fixed-income group, to share a few thoughts on Europe.
Q: How has Europe performed over the past 12 months? As you may recall, European politics and debt-crisis issues were very much in the limelight about this time last year. In Italy, a national election failed to yield a clear winner, spawning uncertainty that caused Italian 10-year bond yields to fluctuate between 4.1% and 4.9% for most of 2013. In nearby Cyprus, a financial crisis and terms of a bailout shocked the European market. But a secondary plan that protected insured and most small depositors was approved and well received by the market, calming fears of another potential Lehman-like event.
As we moved into summer, the European economic recovery began to seed itself, with the 17-nation euro area emerging from its record long recession after six consecutive quarters of contraction. In Germany, business confidence rose to its highest levels in 16 months, investor confidence hit three-year highs, unemployment continued to trend down and in September, Chancellor Angela Merkel, whose government has presided over a strong domestic economy while also moving to back controversial financial aid to other European Union (EU) members, easily won a third term.
Developments were largely encouraging also among the smaller, peripheral European economies, as well, with all members posting improving economic trends. The improving scenario helped the euro gain value over 11 of 17 major currency pairs over the past 12 months, though the European Central Bank (ECB) maintained a cautious focus on downside risks. In May, the ECB cut a key benchmark rate a quarter point to 0.50% and made similar cut in early November, to a record low 0.25%.
Elsewhere in Europe, the British economy finally emerged from slumber. It expanded at its fastest pace in three years in the three-month period ended Oct. 31, helping the British pound to gain significantly against the euro. Successive interest rate cuts in 2012 by Sweden’s central bank began to bear fruit, spawning increases in consumer confidence, retail sales, employment and manufacturing. In contrast, Norway’s economy appeared to slow late into the reporting period, helping the Swedish krona gain significantly against the Norwegian krone.
Q: How did the Federal Reserve’s actions—or inaction, as it were—impact Europe? As often is the case, events in the U.S. overrode the performance of European markets for much of the past 12 months, particularly over the summer and going into fall. Fueled by strong hints from Fed policymakers, global bond markets had primed themselves for a moderation of quantitative easing, pushing yields up on those expectations over the course of summer.
Then the Fed in mid-September surprisingly decided to put off any action, causing global yields to retrace their run-up since early July. At their apex, benchmark 10-year German yields had briefly tested levels above 2%, and their French counterparts nearly reached 2.70%. By the end of October, they were back down to 1.67% and 2.25%, respectively.
Q: What is your outlook for the next 12 months? We feel the global macro landscape currently embodies three key risks that will ultimately shape financial markets, including those in Europe. The first element remains Fed monetary policy—when will it start to taper, and by how much? Is new chair Janet Yellen more dovish or less dovish than Ben Bernanke, and how much clout will she wield over other policymakers when trying to reach consensus? There’s a lot of uncertainty there.
The remaining two risk factors facing global markets are Chinese and European in orientation. On the former, has China successfully engineered a soft landing? On the latter, will Europe’s fragile recovery hold up? Reports early this month weren’t all that encouraging. They showed eurozone unemployment unexpectedly reaching 12.2% in September, matching August’s upwardly revised 12.2%, and eurozone CPI falling to just 0.7% year-over-year, well below the 1.1% consensus and the ECB’s 2% target. It was this report that prompted the ECB to cut its benchmark rate to a record low the first week of this month.
Still, while Europe will continue to foster extremes of sentiment and expectations, we think the most likely outcome will fall somewhere in the middle. The EU is not likely to fall back in recession, nor is it likely to experience an economic renaissance. Europe should muddle somewhere in between these two economic poles, with the ECB likely maintaining a very accommodative monetary policy for many months to come and using additional non-traditional monetary policies to increase credit and bank lending to small and medium-size companies.
In such an environment, country exposure is very important. We expect peripheral European government bonds to continue to outperform core government bonds in Europe in 2014, but with additional volatility. The positive performance of European investment-grade corporate and high-yield bonds also should continue on a relative basis, though absolute performance likely won’t be as strong.