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European growth doesn’t look good – but looks can be deceiving.

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Many corporates are affected by volatility in the US dollar, and those whose budgeting periods will be running during October and November should exercise particular caution this year. While the Fed is unlikely to hike this side of December, should the market get a whiff of a Trump victory in the US, the FX markets are likely to become very turbulent.

November will also be busy for reasons other than the US Presidential Election, namely Italy. The date for the Italian referendum has not been fixed yet, but is very likely to be a Sunday between 13 November and 4 December. The object of the constitutional reform is the substantial change of the Senate of the Republic from a fully operational, 315 MP-strong legislative body with equal legislative powers to the Chamber of Deputies, to a much leaner 100 MP-strong representative body of local authorities (i.e. “Regioni”). The new house mandate would be to ensure that  new laws approved by the lower house would be compliant with both European and local authorities’ regulations, as well as providing immediate feedback on the impact that those laws would have on the ground. 

The clear aim of having a much faster legislative process has been welcomed by a significant majority of Italians. However,  the means by which the proposed law reached its final stage (with particular emphasis on the way contingent political issues influenced various stages of the drafting), and concerns over the perfect coherency of the reformed articles with the unalterable body of the Italian Constitution, make the referendum outcome rather unpredictable. There will be no quorum on the vote, and should the referendum decision be negative, the Italian government is likely to lose the confidence of the Parliament – the consequence of which would be either a very weak government or fresh elections. Either way, this would provide another opportunity for market instability - particularly if, by November, Italy has moved again into recession.

Eurozone growth at 0.3% for Q2 was as expected but still rather weak. However, the figure doesn’t tell the full story, because growth is even more muted in particular countries. Italy and France, for example, had zero growth, highlighting once again their weak positions, particularly given the  British referendum and what could actually become an even weaker Q3. At the opposite end of the spectrum, Spain has proven remarkably resilient in the face of the current political blockade: GDP growth has remained steady at 0.8 per cent for four consecutive quarters, putting the economy on course to grow by more than three per cent this year. This justifies the 10 year Bonos trading at 0.93% and 15 basis points below the Italian BTPs, and Spanish outperformance is also likely to continue as a trend since other countries with stronger links to the UK may have a dip in economic output towards the end of the year.

Germany’s political environment is yet to cause much of a stir, but the third place Merkel’s CDU obtained in Mecklenburg-Vorpommern, together with AfD’s consistent popularity, is testament to the shifting political powers across the Federation to look out for in the build up to federal elections in October 2017.

It is worth noting for the record that the 10 year interest rate swap against 3m Euribor is trading at 0.11%, the lowest level ever, and about 40 basis points lower than six months ago. With the swap curve trading below zero for maturities up to nine years, the current market provides both a great moment to consider pre-hedging of fixed rate notes, and a great source of practical problems in dealing with floating rate financing agreements. The latter typically define the floating rate to be floored at 0%, ie such that when Euribor fixes at negative rates the bank is not forced to pay the borrower. While the economic argument for this feature is clear from a bank perspective, particularly when the loan is expected to be syndicated to institutional investors, it is the cause of two big disadvantages: it impedes borrowers from benefiting from ultra-low interest rates and starts to force borrowers to deal with the frustrating and often extremely structured process of accounting (via bifurcation) for embedded derivatives.

Last, but not least, the reason why rates are trading so low in the Euribor space is that market participants are in growing expectation that the ECB will announce an extension of its quantitative easing scheme on 8 September. The purchase program of €80bn per month is currently set to end in March 2017, but market talk would see it pushed forward to the end of 2017. This will require softening of the self-imposed restrictions on the quality that each country’s central bank can buy (by the end of 2017 50% of presently eligible bonds will have been taken out of the market). More importantly it will require a lot of internal debate among governors on what should and shouldn’t be done.

In this sense the ECB has rarely been 'fast', and we know for a fact that the Governor of the Bundsbank, Jens Weidmann, strongly opposes the whole program. There is a good chance that tomorrow’s meeting will provide no clarity on this argument but, should there be any, the market may move accordingly.

All views expressed here are the author’s own and are based on information available at the time of writing.

 

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