Why you should care
2019 could see churn in the financial markets as populism — and efforts to counter it — spread across the Continent.
With politics souring, the economic outlook darkening and the European Central Bank (ECB) switching off its long-running bond-buying stimulus program, investors are braced for a rough ride in European markets in the opening months of 2019.
The ECB is likely to keep the option open for further potential support if needed, most in the form of cheap funding for banks. Still, 2019 looks set to be a big challenge that will force active managers to prove their credentials. The euro, government bonds and bank stocks are all in line for a shake-up.
“When you remove the crutch, the unsteady walker will be more likely to be shakier or fall, unless they’ve recovered from the underlying problem,” Cutler Cook, head of European equity investing at Californian investment house Paamco, said of the end of the ECB’s bond-buying.
Politics is a prominent concern. With this year’s heavy drop in Italian government bonds still fresh, investors fear that Rome’s budgetary battle with Brussels may be merely the precursor for a wider controversy about debt sustainability as political rhetoric ramps up ahead of the European Parliament elections in May.
Representative democracies find themselves under serious pressure and increasingly bypassed.
Didier Saint-Georges, French asset manager, Carmignac
French President Emmanuel Macron’s promise in December to boost public spending in an effort to assuage populist protests also showed that Europe’s fiscal challenge can spread to key eurozone states.
“Representative democracies find themselves under serious pressure and increasingly bypassed by the direct — and frequently confrontational — expression of political and social discontent,” says Didier Saint-Georges, managing director at French asset manager Carmignac. The impact, assuming a boost to fiscal spending, is a blow to bond markets, he adds.
Chris Iggo, fixed income chief investment officer at Axa Investment Managers, echoes that. “Fiscal slippage in a period of slowing growth with concerns about the lack of structural reform at the member state and community level pose the risk of wider sovereign spreads,” he warns.
Falling bond prices also feed through into European banks’ balance sheets in the so-called doom loop, weighing on the outlook of a sector that is still suffering lingering problems after the 2012–14 debt crisis.
For the euro, it is a complex picture. Typically, a shift to tighter policy would boost the currency, but the negative risks to the region’s growth, also noted by ECB President Mario Draghi, and the lower ECB projections for economic expansion for both 2019 and 2020, could exert a greater drag. A strong sensitivity to global trade tensions and to potential Brexit fallout also pose a risk.
However, looking beyond the early months of next year, the euro may benefit from a waning U.S. dollar. U.S. growth is slowing and inflation reduced in November, while the Federal Reserve has signaled it is closer to reaching the point where no further rises are needed to balance the economy.
“It is possible that as early as mid-2019, the relative growth support to the dollar may be perceived to be fading,” said Citi in its global foreign exchange outlook for 2019.
The midpoint consensus is for the euro to trade at $1.20 by the end of next year, up from its current level of around $1.13, and after a period of weakness in the first six months of 2019.
“We see the euro trading at $1.30 by the end of next year as we have a very bearish view on the dollar for 2019,” says Bilal Hafeez, head of European fixed-income research at Nomura.
Fund managers are reluctant to predict which way asset prices will head as large-scale bond purchases cease, not least because there are so many economic and political factors also buffeting markets. But, despite a sell-off in equities and credit in recent months, it seems unlikely that the full effect of quantitative easing’s (QE) withdrawal is yet priced into assets. That could mean further falls and volatility ahead.
“Taper is in the market, but the [QE] flows are too big to say [taper] is in the price,” says hedge fund manager Michael Hintze, head of London-based fund firm CQS.
Hintze, whose firm runs $18 billion in assets, added that the ending of QE will put pressure on European investment grade bonds, which should provide attractive investment opportunities in time.
Whichever way markets move, the ending of QE is likely to be welcomed by active fund managers, who have long complained about the impact of central bank stimulus.
QE has provided an ideal environment for many passive funds such as index trackers, with the S&P 500 stocks index, in particular, offering a long and relatively smooth ascent for investors who simply buy the market and hold on for the ride. Active managers, in contrast, have often struggled, blaming QE for causing assets to move in unison, with insufficient differentiation between cheap and expensive or good and bad ones.
Hintze says he expects valuation dispersion in credit as QE ends. “That will provide opportunity for active managers,” he says. His fund is betting on Italian senior credit and some European Union bank and insurance companies to perform well relative to the region’s high-yield bonds.
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