Deflated Expectations

This edition of CIO Weekly Perspectives comes from guest contributors Patrick Barbe and  Yanick Loirat of Neuberger Berman’s European Investment Grade Fixed Income team.

Carry strategies have been ineffective in European investment grade fixed income.

The German government yield curve is extremely flat and negative out beyond 15 years—but that is only the most extreme example of a situation that exists across most of the continent and across both government and corporate markets. In that environment, sitting on bonds and waiting for coupons may not produce attractive returns.

You might be able to enhance returns by getting active, however. Low yields and flat curves make a strong case for being flexible with duration and credit risk, exploring opportunities in southern Europe and (our focus in this column) taking advantage of value in inflation markets.

‘QE Infinity’

This may not be an obvious place to look in Europe.

Today, inflation is barely half the target rate of the “below-but-close-to-2%” target set by the European Central Bank. The ECB has responded with a new quantitative easing program. The main difference from the first iteration is a reinforcement of forward guidance: The implication is that asset purchases will persist, and that the key interest rates will remain at their present levels for as long as the inflation target is not achieved in a robust and sustainable way.

It is interesting, then, that many economists, investors and commentators have been referring to this not as “QE2,” but as “QE Infinity.” They doubt that the euro zone will see 2% inflation ever again.

Looser Fiscal Stance

We think there is more chance of higher inflation in Europe than this implies.

With Christine Lagarde as its president, the ECB is perhaps more likely than it was under her predecessor, Mario Draghi, to find consensus within the central bank’s governing council and work hard to persuade the euro zone’s political leadership to provide fiscal stimulus. Lagarde has already mentioned that monetary policy has negative “side effects” in her inaugural testimony before the European Parliament. Moreover, new leadership of Germany’s Social Democratic Party has also increased the probability of a looser fiscal stance, to keep the “grand coalition” with Angela Merkel alive.

In addition, as we have written in the past, many of the disinflationary challenges the euro zone faces are now exogenous, such as high uncertainty around global manufacturing and trade. Levels of lending and consumer confidence in the domestic economy are robust due to low interest rates and rising employment. Combined with resilient capex, this has left the economy with very little unutilized capacity.

Should some of the global issues weighing on inflation and euro zone business confidence begin to lift—with a phase-one U.S.-China trade deal, some clarity on Brexit, or traction from China’s fiscal and monetary stimulus—2020 could see a combination of rising capex, rising government spending commitments and rising inflation.

Depressed Inflation Expectations

As that unfolds, market participants may well notice just how depressed euro zone inflation expectations have become.

Across the region, the summer and autumn of 2019 saw record-low levels in five-year forward breakeven inflation rates at the five-year tenor (“5Y5Y breakeven inflation”). They have barely recovered since then. Looking to 2020 and 2021, core inflation is forecast to reach between 1.2% and 1.3%, but financial markets are pricing in breakeven inflation barely above 0.6%. There is no clear technical reason for this pricing, given the diminished supply of inflation-linked bonds in the final quarter of this year.

We see attractive valuations in French inflation-linked bonds (OATi), but, in line with our general willingness to seek out value in southern European markets, we think some of the best opportunities may be in Italy.

Here, securities known as BTPs Italia revalue their principal in line with changes in Italian inflation every six months. In case of deflation, coupons are calculated on the nominal principal, providing a floor; even in the event of six months’ deflation followed by six months’ inflation, the investor accumulates the full realized inflation due to this floor. Nonetheless, since the start of the year, with no support from quantitative easing, these bonds have been trading at levels that imply a breakeven rate of close to zero—which we regard as a pessimistic outlook for future Italian inflation.

With accommodative monetary policy here to stay and the economy nearing capacity, it is difficult for us to see the euro zone falling into recession next year. The one risk that could derail things is political risk to processes such as post-Brexit trade negotiations or the U.S.-China trade accord. Against this backdrop, we see value opportunities in some southern European government bonds and credit, and in inflation-linked bonds. Where those two opportunities overlap, in BTPs Italia, we think there is particularly attractive value.