Global Daily – Euro sovereign spreads set to rise

by: Nick Kounis , Aline Schuiling , Bill Diviney , Arjen van Dijkhuizen

Euro Rates: Italy woes and political risk to drive country spreads higher – In yesterday’s Global Daily Insight we presented new rates forecasts, arguing that core government bonds will be supported by macro downgrades and further ECB re-pricing, with curves flattening (see here). Today we present our government bond country spread forecasts (each country’s 10y government bond yield spread over Germany to be precise – see table below). We expect semi-core and – in particular – peripheral spreads to trend higher. This reflects two factors. Firstly, the Italian economy is in recession and the budget deficit is likely to significantly overshoot the government’s target. In addition to likely further disappointments in terms of the macro outlook (we see GDP of -0.3% this year versus the government’s projection of 1%), we think that the measures that the government has implemented will be more expensive than the budget assumes. Overall therefore, we expect the budget deficit to be considerably higher than projected, at close to 3% GDP in 2019 and 2020. Given this, we remain of the view that the government debt ratio will trend up in the coming years. Our base case is that the 10Y spread between Italy’s government bond yield and that of their German counterparts will rise to around 300bp. With fiscal outcomes likely to disappoint, markets may price in more credit risk, especially as this could re-ignite tensions with the European Commission. The rise in Italian spreads will likely also put some upward pressure on semi-core and peripheral spreads, not least because slower growth rates will put pressure on the public finances in many countries.

Second, political risk premiums may rise more generally because of a number of elections in the coming year (Belgium, Portugal, Greece, the European parliament and very likely Spain will all hold elections). In most cases, we expect market-friendly outcomes, but there will still be uncertainty in the run-up to these elections and in addition in some cases there could be unclear results. For instance, government formation might be difficult in Spain and in Belgium.

Limiting the rise in spreads will be ongoing dovish shifts from the ECB. We expect it to signal a longer period of unchanged rates and also APP reinvestments, while we also expect a new TLTRO to be announced. Spreads should start to ease later in the year as some of the elections will be behind us, while growth firms moderately. (Nick Kounis & Aline Schuiling)

US Macro: Weak retail print vindicates Fed pause – Retail sales plunged 1.2% month-on-month in December, the biggest decline since 2009. Excluding volatile autos and gasoline categories, sales were even worse, falling 1.8% mom. This took the year-on-year rate to 2.3% from 4.1% in  November. While retail sales can be volatile month-to-month, and there does seem to be some inconsistency with other retail sector indicators such as the Redbook chain store sales survey, there do appear some fundamental drivers of the weakness too. For instance, one category exhibiting consistent weakness over the past year is furniture & homeware, which could reflect the weakness in housing. Indeed, annualised existing home sales fell under 5mn in December having declined throughout 2018 – well below the recent peak of 5.7mn in November 2017. This is likely to be affecting purchases of big ticket household items. Another area of persistent weakness is department stores, which have faced structural headwinds from online competition. In contrast, auto sales and food services/drinking places remain relatively robust. All told, while a very weak print, we would hesitate to read too much into a single release, and we could easily see considerable payback in the January numbers. However, we would also not gloss over the weakness this highlights in certain parts of the economy (particularly housing). The data will also embolden the FOMC that its decision to hold off on further rate rises was a prudent one, and it supports our view that the peak in growth – and the rate hike cycle – is behind us. (Bill Diviney)

China Macro: Trade data better than expected, but could be distorted – This morning, Chinese trade data came in better than expected. After remaining solid during January-October 2018 despite the trade conflict, Chinese foreign trade data started weakening since November, and poor December data added to fears of a global slowdown. As we highlighted before, one should not attribute the drop in Chinese imports fully to the slowing of domestic demand. Various special factors are at play: the slowing of exports (as a big chunk of Chinese imports is export-related), the effect of import tariffs implemented last year, payback from trade conflict related frontloading, lower commodity prices and base effects from strong trade numbers end 2017. Meanwhile, the January trade data came in much better than expected. Import growth remained negative (-1.5% yoy), but much less than expected (-10.2% yoy) and in comparison to December (-7.6%). On a mom basis, imports rose by 8.7% in January. In terms of destination, imports from the US were the negative outlier (-41% yoy), obviously a consequence of the trade conflict. Import growth from the EU (+8.5% yoy) and Germany (+5.8%) was solid. Meanwhile, export growth was in positive territory again (+9.1% yoy, versus consensus -3.3% and December -4.4%), taking away some of the fears of a sharp slowdown in external demand. That said, China’s monthly trade data are notoriously volatile, particularly at the start of the year reflecting to year-to-year changes in the timing of China’s New Year holiday break. That means that one should be careful in drawing sharp conclusions from monthly trade figures. Still, recent export and import PMIs indicate some turnaround too, possibly also reflecting hopes of a positive outcome of US-China trade talks that have resumed this week. We think an extension to the 1 March ‘deadline’ has become more likely. See for further background our China Watch: Will the Pig arrive in time this year?, published earlier today (Arjen van Dijkhuizen)