Tatton – Europe’s beacon of hope shines light on old problems
This prospect is making capital markets excited. For most of the year, a dreary economic outlook (and drearier virus crisis) meant investors held some scepticism on European equities, even if this year they have traded level with their US counterparts. Low growth expectations, coupled with continued European Central Bank (ECB) buying, were an anchor on government bond yields, which stayed down at historically low levels, even as the US saw a pick-up. But with hope now on the horizon, bond yields are on the up. Germany’s ten-year debt yields rose temporarily to their highest level since 2019 – almost touching the 0% mark at one point – while yields in all other major European Union (EU) economies remain positive.
Bonds are being pushed by rising inflation expectations, with Eurozone five-year forward inflation swaps (a measure of long-term price expectations) at their highest levels since late 2018. Crucially, rising yields do not seem to be overly worrying the ECB. This marks a big change from just a couple of months ago, when a move up in Eurozone yields led to damage control. Policymakers warned against tightening financial conditions, and announced emergency bond purchases would be at a “significantly higher pace than during the first months of this year”. It appears those words did the trick – purchases remained ongoing but not necessarily in greater amounts.
That the ECB seems rather nonchalant this time round is significant. It suggests officials think the recovery is real, and that the Eurozone economy is strong enough to withstand a move higher in bond yields. This is understandable, given where the market moves are coming from. In February, soaring US growth expectations pushed bond yields up around the world – even though regions including the EU were still languishing. This time, expansion hopes fanning inflation expectations are coming from Europe itself.
The US comparison is interesting from a market perspective. The world’s largest economy has undoubtedly been the strongest this year, with a rapid vaccine rollout and significant fiscal stimulus exciting global investors. However the latest data shows a plateau in that rampant growth. And, while activity is stabilising at a decent level, the hype around American assets has been so great this year that there is not much room to budge higher. Europe, on the other hand, has occupied the other end of the spectrum – severe restrictions and the very public vaccine fiasco painted a rather dark picture. But now things are ramping up, markets are shifting focus.
That shift has obvious benefits for European assets, but also shines a light on issues that were best left forgotten. Hand-wringing over the European recovery fund – a hard-fought fiscal package for all EU members – had investors sweating earlier in the year. And, even though political problems there have dialled back, there is yet again more focus on EU’s perennial problem child: Italy. The EU’s third-largest economy has a host of long-standing problems that have been brushed under the rug by the pandemic. Its banking sector has struggled under a raft of non-performing loans since the financial crisis (even if some progress has been made), while its old fashioned and complex legal system has long been a barrier for investment. These structural problems are one of the main factors behind Italy experiencing more than a decade of low growth and disinflation – further compounding its debt issues.
The situation may be worsened by Brussels’ strict budgetary rules, though any spending is only likely to bear lasting fruit if accompanied by structural reforms. The malaise has been a repeated site of political tension, with populists gaining popularity in Italy and getting into regular spats with eurocrats. The script is always the same: tensions flare between Rome and Brussels; fears of a Eurozone breakup rise; officials find some way of kicking the can down the road; and repeat.
Markets were happy earlier in the year when technocrat and former ECB governor Mario Draghi assumed Italy’s premiership after the fall of a fractious government featuring the far-right Lega Nord party. Draghi commands financial expertise and significant respect in Brussels, so markets hoped his technocratic unity government could find a way out of trouble. Reality is always more difficult.
While Draghi is popular among international investors, he still has a deficit with the Italian population, simply because he was not elected to office. Moreover, even if he manages to last until Italy’s next scheduled election in 2023, it would be a tall order to solve the country’s structural problems by then. According to latest reports, Italy’s President, Sergio Mattarella, said that he plans to retire next year. Lega Nord leader and former deputy prime minister Matteo Salvini was quick to suggest Draghi as the president’s successor. If that happens, Draghi will have to relinquish the premiership, likely triggering an election that Salvini stands a good chance of winning. Nothing has been decided and opinions on the actual outcome vary, but already this is a scenario keeping observers occupied.
Any political uncertainty would certainly be a headache for capital markets – potentially dampening the outlook for the wider Eurozone as it dampens hopes for structural reform. With that issue on the horizon, investors may start to wonder what the Eurozone looks like once the ECB starts buying fewer securities – which for now has kept Italy’s yield spread versus the German bund very tight and therefore far less burdensome than it had been at times in the past. For now, we can at least take comfort that these problems are coming from a place of strength.
Lothar Mentel
CEO Tatton Investment Management Limited
CIO Tatton Asset Management
Rule of Six
With the number of coronavirus cases rising across the UK, the Prime Minister was back on the Downing Street podium last Wednesday to announce new measures. As we enter the autumn, with the country at a critical moment and the average rate of new infection four times higher than in mid-July, the government announced the introduction of the rule of six. From Monday (14 September) social gatherings of more than six people (of all ages) are banned in England. This limit applies to indoor and outside settings and is enforceable by police, who will issue fines or make arrests.
A support bubble or single household larger than six, will still be able to gather and COVID-secure venues such as gyms, restaurants and places of worship, can still hold more than six in total. The rules do not affect education and work settings.
Boris Johnson said, “we must act” to avoid another lockdown, adding, “Let me be clear – these measures are not a second national lockdown – the whole point of them is to avoid a second national lockdown… I wish that we did not have to take this step, but, as your Prime Minister, I must do what is necessary to stop the spread of the virus and to save lives… it is so important that we take these tough measures now.” Matt Hancock said the new rules will not be kept in place “any longer than we have to.”
During the briefing, the Prime Minister also outlined ‘Operation Moonshot’, an expansion of testing to ten million a day by early 2021. Frequent testing of the population would allow people without the virus to conduct their lives as normal, allowing the economy and society to remain open despite the virus being in circulation. Boris Johnson said the government was “working hard” to increase testing capacity to 500,000 tests a day by the end of October.
Quarantine list additions: Last week, in a change of policy for the government, England introduced island-specific quarantine, rather than restrictions applying to an entire country. Travellers arriving in England from seven Greek islands needed to self-isolate from 4am last Wednesday. Mainland Portugal was placed back on the quarantine list last week, effective from Saturday (12 September) morning. Meanwhile, Sweden has been added to England, Scotland and Wales’ safe lists.
Economic growth and trade talk wrangling’s: According to official figures from the Office for National Statistics, the UK economy grew by 6.6% in July, the third month in a row of economic expansion. Despite this, output remains below prepandemic levels and the ONS outlined the UK ‘has still only recovered just over half of the lost output caused by the coronavirus.’ The UK’s economy is 11.7% smaller than it was in February.
Despite subdued trading, the FTSE 100 ended higher last week. Trade deal negotiations between the UK’s Brexit negotiator Lord Frost and his EU counterpart Michel Barnier continued last week. The UK has published a bill to rewrite parts of the withdrawal agreement it signed in January, but the EU is demanding the UK drops plans to alter it. Lord Frost said, “Challenging areas remain and the divergences on some are still significant”, but UK negotiators “remain committed” to reaching a deal by the middle of October.
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Covid 19 update
As Storm Francis lashed the UK last week, another storm was brewing as the government took a late U-turn regarding the use of face coverings in schools in England. From the beginning of September, secondary pupils and adults in local lockdown areas of England and in areas facing extra government restrictions, will be required to wear face coverings when moving around the school, in corridors and communal areas.
Any secondary school in England will have discretion to introduce the use of face coverings in communal areas, where social distancing is not possible, a move which has prompted criticism from some teachers, with the announcement last Tuesday being made just hours before schools reopened in Leicestershire. The guidance does not include the use of face coverings in the classroom during lessons, where the government says they could ‘inhibit learning.’ The guidance extends to further education colleges but not to primary schools. Education Secretary Gavin Williamson said the new policy follows updated advice from the World Health Organisation, “Our priority is to get children back to school safely. At each stage we have listened to the latest medical and scientific advice… I hope these steps will provide parents, pupils and teachers with further reassurance.”
Eat Out success prompts extension – Some restaurants are keen to continue offering discounted meals in September, following the success of the Eat Out to Help Out initiative in August. The scheme ended on 31 August, but nationwide chains including Prezzo, Harvester, Toby Carvery, Bill’s and Pizza Hut are amongst those due to take part, although the eateries will have to cover the costs themselves.
Support for those self-isolating on low incomes – From Tuesday (1 September), workers on low incomes living in parts of England where there are high coronavirus rates will be able to claim up to £182 if they have to self-isolate. Strict eligibility criteria mean people claiming Universal Credit or Working Tax Credit, who are unable to work from home, will qualify for the £13 per day payment. The benefit is initially being trialled in parts of North West England. Eligible individuals who test positive and are employed or self-employed, need to isolate for 10 days and will receive £130. Eligible members of the household, who would have to self-isolate for 14 days, will be entitled to a maximum of £182. In addition, anyone who is told to self-isolate by NHS contact tracers and meets the eligibility criteria will be entitled to £13 a day for the duration of self-isolation.
Renewed optimism US stocks hit record highs last week after Federal Reserve Chairman Jerome Powell outlined the central bank’s strategy for avoiding future crises and inflation control measures. During the week, stocks rose amid renewed optimism about US China trade tensions, with both Chinese Vice Premier Liu He and US Treasury Secretary Steven Mnuchin renewing their commitment to a trade deal.
Quarantine list additions – Due to a rise in infection rates, quarantine rules were implemented on Saturday morning for travellers returning to the UK from Jamaica, Switzerland and the Czech Republic. Cuba has been added to the list of countries now exempt from quarantine.
In other news The government is preparing to launch a campaign this week aimed at encouraging employees back to their workplaces. Lockdown restrictions in parts of Greater Manchester, Lancashire and West Yorkshire will be lifted on 2 September due to ‘positive progress’, the government has announced.
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