Europe is facing a ‘winter of discontent’

1st December 2015


David Roberts, head of fixed income at Kames Capital, looks at why the eurozone is facing its bleak midwinter…

I am writing this on 30 November, my birthday and the national day of Saint Andrew, Scotland’s patron saint. It is also three days before Thursday’s ECB meeting, when some important decisions will be made that will likely shape investment returns for the whole of 2016. Over the past 20 or so years I’ve been left looking foolish by the decisions of central bankers on various occasions.

While recognising that I could be about to do so again, here are my predictions for this week’s meeting and into next year. For what it’s worth I believe the ECB will formally extend the tenure of its asset purchases and cut the deposit rate. I do not think they will extend purchases far beyond existing assets and I am not sure they will increase monthly amounts. This would probably satisfy markets leading to most Euro assets rallying short-term. If so, I would likely sell. If they do much more and prices spike materially higher, I will sell and may not hold many Euro bonds throughout the entire 2016.

I believe Janet Yellen will belatedly raise US rates. She will do her best to sound uber-dovish, but the market will not believe her. By the end of 2015 it is possible that 10-year US bonds will pay 2% more than the German equivalents. If so, I intend to buy, probably funded from Euro sales noted above.

There is a real possibility that the Euro will fall below US$1.00, a devaluation of nearly 20% year-to-date. With the benefit of devaluation largely still to come, plus some prospect (base effect, if nothing else) of more stable commodity prices, there is a risk that Euro growth and inflation surprise on the upside by mid-2016. If that happens and we have a sniff that Northern members of the ECB may even consider tightening policy, then that 2% yield differential between Bunds and Treasuries will reduce swiftly. Core Eurozone inflation is already above 1%.

I believe there will be a better entry point short-term. However, if asked today how to position for 2016, I would recommend shorting core Euro sovereign debt, buying Euro-domiciled equity in companies with global earnings, buying intermediate to longer-dated US Treasuries and probably diarise to buy emerging markets in June or July. I would also buy some Euro corporate debt, but concentrate on larger and more liquid names to allow exit sometime next year, possibly into US, UK or similar.

Of course the risk is that global central bank policy does not lead to a weaker Euro, to European growth and inflation. Then in two or three years’ time, as the US economy starts to cool, European unemployment is still north of 8% and we have to pray the Chinese economy is consumption-led or I’m afraid it’s recession once more.

Finally, an easy one: China will grow around 5% next year. Worrying about that does not keep me awake at night. But as for Brazil, now there is a risk.

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