PrintDeterioration in risk sentiment, triggered by Greece's economic crisis, is unlikely to let up for European financial markets. A EUR110bn financial support package for Greece, and EUR750bn stabilisation mechanism for the eurozone, has failed to quell investor fears over the bloc's structural deficiencies (over-leveraged private sector, enormous fiscal deficits, fractures in the monetary union, and in some cases poor international competitiveness ), which have left the region fundamentally weak. This translates into a fairly poor growth outlook over the medium term. Economic data from the first quarter is supportive of our view that:
Domestic demand, and more broadly economic growth, will remain weak.
Deflationary forces will dominate.
Monetary policy will remain loose for a protracted period.
Though technically Europe has emerged from recession, Q1 figures have reinforced our view that the recovery will be neither quick nor strong. The UK economy contracted 0.3% y-o-y in Q109 (though expanded by a modest 0.4% on a quarter-on-quarter basis), while Spain plunged 1.3% and Greece 2.3%. Meanwhile, growth around 1% for Italy, France and Belgium, as well as a slightly better performance from Germany where national output increased 1.6% over the same period, is still concerning given the substantial degree of fiscal expansion.
The eurozone economy as a whole experienced growth of just 0.5% in the first three months of the year. Given that government's across the region are under increasing pressure to get their fiscal houses in order, which will mean tax rises and severe spending cuts, demand will likely weaken in the second half of the year.
In addition, though headline inflation has been edging higher in the eurozone (and the UK), this owes largely to euro weakness, the rally in global oil prices and statistical base effects from Q109. The weakness of domestic demand, exacerbated by restricted bank lending (especially to households), lingering high unemployment and the massive private sector deleveraging requirement, continue to favour deflation over inflation.
That the relatively uncompetitive economies such as Greece, Spain and Portugal must grapple with internal devaluation in order to rein in respective real effective exchange rates, is further supportive of declining prices (and most importantly a fall in unit labour costs).
Given this fundamental view, we believe:
Concerns over fiscal sustainability and sovereign debt loads, internal devaluations at the periphery of the eurozone, and monetisation of government debt by the European Central Bank will keep the euro weak.
Low inflation (and even outright deflation) and weak underlying demand bodes poorly for the outlook for equities.
A protracted period of low interest rates and elevated risk aversion will favour German bunds.
The relative flexibility of the UK economy and floating currency, coupled with a fairly favourable average maturity of government debt, could offer opportunities in UK over eurozone financial assets at some point down the line.
ECB Losing Credibility
The ECB's recent decision to begin purchasing government debt across the eurozone reinforces our increasingly bearish outlook for the euro. Although debt monetisation will ease refinancing pressures on heavily indebted governments and help stabilise sovereign balance sheets, it comes at the cost of a weaker currency as euros are unleashed on the market. As the weekly chart below shows, the euro has already smashed through major support at US$1.2800/EUR and is homing in on the US$1.1600/EUR level, which could prove the last major obstacle before a move back to dollar parity.
Further signalling the declining appetite to hold the currency, and growing concerns over the ECB firing up the printing press, gold prices in euros have punched through a major resistance level (going back to 2006) at EUR880/oz and continues to hit fresh highs. While we cannot discount the possibility of gold turning into a bubble over the medium term (especially given the growing critique of major fiat currencies), for the time being further gold strength will likely be mirrored by a weaker euro and will be reflective of deteriorating risk sentiment towards euro financial assets.
Continued euro weakness will also likely feed through to the CE-3 currencies (Polish zloty, Czech koruna, Hungarian forint). Having sold off sharply on the back of Greece's economic crisis, the CE-3 currencies have failed to make up lost ground, with the zloty (our favourite currency in the region) in particular lingering outside of its medium-term appreciatory trend channel.
Strategic Outlook For Equities Is Weak
The biggest losers of weak demand and deteriorating risk sentiment are the region's equity markets. We have long stressed that the stellar rally in European wide equity indices (with some markets up over 200% since Q109) was not reflective of underlying fundamentals and as such, a major correction would be on the cards at some point. Poor economic growth and low inflation data across the region have supported our view that demand conditions will remain weak. With a number of indices appearing to have lost momentum in recent weeks and rounding out, the stage could be set for a major slide in equities.
Despite bouncing off support at 5,650, the subsequent rally of the German DAX was insufficient to take the index back to the top end of its current trend channel. With the index sliding down to 6,071 at one point on May 19, we highlight 5,700 as key to watch on the downside, with a decisive push through this level paving the way for additional losses to 5,200 in the first instance.
The technical picture emerging from the FTSE 100 tells a similarly story. The bounce off support at 5,100 has proved short-lived after the index failed to push into its previous upward trend channel, with a retest of support now on the cards. A breach of this level would presage a further move down to 4,500.
We stress that with the aforementioned support levels still in play, we will not adopt an outright bearish equity view for the time being. However, a decisive push below these levels would necessitate a reassessment of this view, with a major Europe-wide equity market correction looking increasingly likely.
German Bunds: A Flight To Safety
While weak demand, low inflation and deteriorating risk sentiment spell trouble for the region's equities, we believe that this will continue to favour German bunds. As the largest economy in Europe and traditionally the most fiscally prudent, investors have poured into government bonds as a way of maintaining some exposure to the region, while stripping out the volatility which plagues financial markets in the weaker European economies. With a singular central bank interest rate for the eurozone, though varying financial and economic risk, there is little incentive to keep euros on deposit in stricken economies such as Greece, rather than a more robust economy like Germany.
That yields on 2-year paper have compressed to 0.54% following the bounce off support at 1.00% is a telling sign of Germany's status as a regional safe haven. With the ECB set to keep monetary policy loose for a protracted period (weak domestic demand and no near-term inflationary pressures do not justify hiking rates just yet), the concomitant flight to safety into German bunds will keep yields extraordinarily low.
Moreover, while there is scope for government bond yields across the board to compress on the back of ECB debt monetisation, we stress that volatility risks are significantly higher in the fundamentally weaker economies at the eurozone periphery relative to the core. In particular, although Greek 2-year yields collapsed to 7.24% on May 19 from 17.96% on May 7 (reportedly yields hit 38% in intraday trading), Greece's economic crisis is far from over, which will prevent a complete normalisation of yields and volatility towards the regional bellwethers such as Germany.
Potential Opportunities For UK Over Eurozone
Having spelt out a fairly bleak outlook for eurozone financial markets, the key question remains 'where does the UK fit in?' Public finances are a mess, the economy is lagging the eurozone recovery and recent elections have ushered in the first coalition government since WW2. At first glance, the UK is certainly a basket case. The pound has taken a beating following the May 6 ballot, tumbling down to US$1.4537/GBP following the breach of support at US$1.4800/GBP. Further downside is certainly in the offing, with support at US$1.3600/GBP the last obstacle before a full-on collapse towards dollar parity. Again, this is still a risk at this stage, rather than a key view.
For the time being, we expect sustained sterling weakness on the back of the eurozone crisis and more general elevation in risk aversion. However, this will support the export sector and broader economic growth.
Given the extreme stresses facing the euro, particularly risks of sovereign default and internal devaluations for some uncompetitive economies, we believe that the flexibility of the British pound will stand the UK in good stead and could afford opportunities in the FX market. As such, we highlight EUR/GBP as one to watch. The cross rate so far remains committed to an appreciatory trend channel (in the pounds favour), with resistance at EUR0.8400/GBP key to unlocking more sustained sterling strength.
Meanwhile, the government bond market tells a slightly different story. Yields on short-dated paper look increasingly similar to Germany bunds, with 2-year gilts pushing through resistance at 0.95% and sliding down to 0.86% on May 19. Indeed, it almost appears to be a race to the bottom for UK and German short-end yields.
While the UK is certainly not a safe haven, we believe that the formation of a Conservative-Liberal Democrat Party coalition government (which will likely be better for fiscal consolidation than a botched and fractious coalition of Labour and minor parties), coupled with a fairly long average bond maturity and expectations of sustained low central bank interest rates, suggest bond yields will remain low for now.
In addition to a more favourable maturity structure of UK debt, the ability of the Bank of England to engineer inflation over the medium to longer term, further suggests that a default in the traditional sense is not on the cards (although admittedly this would imply technical default through inflation).