February 3, 2014
Ken Orchard, European portfolio manager, and Ivan Morozov, European sovereign analyst, share their thoughts on the likely themes to emerge and gain prominence over the coming year in Europe. They believe the worst of the European financial crisis is over and do not anticipate a return to the volatile times of 2011–2012. However, 2014 will likely be a mixed year for the eurozone. Numerous chronic conditions remain that will weigh on economies' growth prospects and prevent a rebound in sovereign creditworthiness. There is also potential for political issues to destabilize some countries. Idiosyncratic developments are likely to have a greater influence over sovereign bonds than has been the case over the past couple of years.
The two-speed eurozone will return
We expect the eurozone's muted economic recovery to continue in 2014. Regional gross domestic product (GDP) growth for the year is likely to be near the consensus forecast of 1.1%. But few countries will grow at the average rate. Instead, there will probably be divergence, with some countries growing more quickly and other countries growing slowly (if at all).
We believe the "growers" camp includes Germany, where GDP growth is expected to be close to 2% and fiscal balances are healthy. Ireland is the only periphery country that is part of this group. In spite of significant fiscal consolidation, strong exports and a small, open economy mean that growth could reach 1.5% this year.
We believe the "stagnaters" are countries with weak public finances and/or highly indebted private sectors. This group includes France and the Netherlands. The French government is finally getting serious about reducing the budget deficit, which will be a drag on the economy, particularly in the first half of the year. The Netherlands continues to grapple with high private sector debt.
Spain and Italy tilt more toward the second group. The governments of both countries halted fiscal consolidation in the second half of last year to boost the recovery, but fiscal tightening will need to return at some point. Although both economies have been growing recently, high private sector debt, particularly in Spain, means that deleveraging is likely to weigh on domestic demand for many years.
Deleveraging: Progress made, more to be done
Although we recognize European countries' progress in reducing foreign currency borrowing, it remains at high levels in the periphery and in France. Current account balances in most periphery countries are now between 0% and 1% of GDP, but they are not sufficiently high to offset the extreme levels of external debt that built up during the boom years between 2000 and 2008. In contrast, France has a small current account deficit and will require more structural reforms to regain competitiveness.
We expect domestic consumption and investment to remain weak for several more years, as higher export growth to the broader eurozone (notably Germany) and global economies (Japan and emerging markets) will only absorb around half of the necessary external adjustment.
Deflation worries to build
Eurozone inflation consistently surprised expectations to the downside in 2013. Underlying inflationary pressures are currently very low, and headline inflation could decline further if energy prices remain stable. The European Central Bank (ECB) has tried hard to stave off concerns about deflation, and so far it has been successful. But ongoing disinflationary forces are likely to cause deflation worries to build.
ECB will continue easing monetary policy
In our view, there could be four reasons for additional ECB easing:
- To improve banking sector liquidity
- To offset the impact of restrained bank lending—a likely response to the ECB's asset quality review and stress tests
- To stem worries about slow growth and deflation
- To mitigate the impact of rising money market rates in other countries, notably the U.S.
The preferred option for the ECB will depend upon the specific concern. The need for liquidity and the easing of credit conditions might require another (but smaller) round of long-term refinancing operations—the ECB's program of low-cost financing of maturities of less than three years to eurozone banks. Meanwhile, growth concerns and higher U.S. rates could be tackled through another ECB rate cut (to 0.10%–0.15%), enhanced forward guidance, and/or purchases of securitized assets.
Budget deficits will be closer to targets
We expect government budget deficits to be closer to targets in 2014, after several years of missed targets. We believe that extraordinary expenses should be less prevalent as most countries have recapitalized their banks and stabilized their banking systems. Furthermore, labor markets appear to have stopped deteriorating, while governments have also become more realistic about revenue expectations.
European Parliament elections unlikely to lead to changes in political agenda
European countries will hold elections to the European Parliament in May 2014. The Parliament plays more of a checking role than a legislative one, but it has the powers to deflect the European Commission's proposals, including the European budget, which makes it an important institution.
We do not think the election will lead to changes in European policymaking, despite growing anti-eurozone sentiment in some countries. Traditional pro-European parties will still dominate the political agenda. There will be limited appetite for new initiatives at the European level in the several months prior to and after the elections. Most of the European efforts this year will be concentrated on banking reforms.
Stress tests will reduce banks' willingness to lend
We believe that banks will limit risk taking in 2014 due to the ECB's upcoming asset quality review and stress tests, which are required before the ECB assumes supervisory authority over European banks from national bodies in November 2014. This means there will be very limited credit supply to the real economy and negative pressure on domestic demand, especially in weaker eurozone economies, such as Italy and France. We do not think stress tests will result in large calls for new bank capital, given the ECB's close supervision of banks in countries participating in the "troika" rescue programs, which are financed by the ECB, International Monetary Fund (IMF), and European Union (EU) Commission.
Portugal will get further support, with no debt restructuring
In 2013, Ireland and Spain celebrated successful exits from troika rescue programs, with both countries returning to full-market funding. However, the most complicated program exit is still ahead of us: Portugal. In contrast to Ireland, Portugal has greater structural issues and higher debt levels, which could continue to complicate the market access for the government and also raises general questions about debt sustainability.
We think that the most likely outcome will be for Portugal to get further support from the troika, probably in the form of a credit line with strong conditionality. The final decision is expected in the first quarter of 2014. The troika, which has lauded the progress the Portuguese government achieved over the last few years, should continue its general supportive stance.
Nationalist movements will lead to further regional autonomy
Nationalist movements in parts of Europe will experience a higher profile and potentially their first tangible gains in 2014. Scotland will hold a referendum for independence in September. The president of Catalonia has announced a referendum in November, although the central government will attempt to block it on constitutional grounds. Belgium will hold parliamentary elections in May 2014, where the Flemish regionalist party, N-VA, has strong chances to show the best result in its history.
The headline risk from these events could push borrowing costs higher in Spain and Belgium, as both Catalonia and Flanders are very large and wealthy parts of their respective countries. In contrast, we do not think UK bonds would be under any pressure because of the Scottish referendum, as Scotland is relatively small part of the UK economy.
Eurozone will grow a bit more...and then stop
Despite rising anti-euro sentiment from within the eurozone, the bloc remains the option of choice for smaller European countries. Latvia officially adopted the euro currency on January 1, 2014. Lithuania has reaffirmed its commitment to apply for euro membership in 2014, which, subject to meeting all the criteria (and it should), will make it the 19th eurozone country. We think these two Baltic countries are the last to adopt the single European currency in the foreseeable future. Other EU countries either have a long way to go to meet the Maastricht Treaty criteria for euro currency convergence (Bulgaria, Croatia, Hungary, Poland, and Romania) or intend not to join the bloc (Czech Republic, Sweden, Denmark, and the UK) to keep independent monetary policy.
We expect all of the existing eurozone members to stay in the bloc. Periphery countries have been benefiting from European support in the form of loans and ECB monetary operations—a luxury they would not receive outside of the euro area. With a large part of the macroeconomic adjustment behind, incentives to leave have clearly been reduced. As economies start to grow, political leaders will have stronger support for eurozone membership, limiting the growth in popularity of the anti-European forces.
This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action. The views contained herein are as of January 2014 and may have changed since that time.