Jean Boivin, Head of BlackRock Investment Institute together with, Elga Bartsch, Head of Macro Research, Mike Pyle, Global Chief Investment Strategist for APAC and Scott Thiel, Chief Fixed Income Strategist, all part of the BlackRock Investment Institute share their insights on global economy, markets and geopolitics. Their views are theirs alone and are not intended to be construed as investment advice.
A decision by the German constitutional court last week could potentially undermine the independence of the European Central Bank (ECB) – and threaten to fuel fragmentation within the euro area in the long run. This comes as the ECB’s actions to cushion the pandemic’s fallout already looked meek compared with the Federal Reserve’s. As a result, we are reviewing our overweight on euro area peripherals, or government bonds from southern-tier nations.
Sources: BlackRock Investment Institute, with data from Refinitiv, May 2020. Notes: The orange line represents the yield spread between 10-year Italian and German government bonds, calculated based on the are the Refinitiv Datastream 10-year government bond benchmark indexes for Italy and Germany. The yellow line represents the yield spread between U.S. investment grade credit and Treasuries, based on the option-adjusted spread of the Bloomberg Barclays U.S. Credit Index.
The German court gave the ECB three months to justify its 2-trillion-euro bond purchase program to the German parliament. Otherwise the Bundesbank – the ECB’s largest shareholder and bond buyer – would have to pull out of the program, the court said. The ruling put a spanner into the works of the ECB’s “whatever-it-takes” commitment – at a time when effective execution of policies is critical to safeguard the economy against damages from the coronavirus shock. As evidence of the vulnerability in the euro area’s hardest-hit economies, the yield spread between Italy’s government bonds and their German counterparts has been widening since late March despite the ECB’s stepped-up purchase program. In contrast, the U.S. investment grade credit spread declined from its March peak and has steadied since mid-April as the Fed’s pandemic response allayed credit concerns. See the chart above.
We have seen nothing short of a policy revolution in response to the coronavirus outbreak – in terms of speed, size and monetary-fiscal coordination. The successful execution of policies and programs is key – and the German court ruling may be a cautionary tale of how execution can be scuppered. Explaining itself to the German parliament shouldn’t be a problem for the ECB. Yet having to do so undermines its independence, a precondition for its “whatever-it-takes” stance. This is partly a consequence of the blurring of boundaries between monetary and fiscal policies – and particularly problematic in the euro area due to the lack of a joint fiscal authority. We had highlighted the crucial role of proper guard rails around policy coordination in dealing with the next downturn.
The bottom line: We are putting our view on euro area peripheral bonds on review despite relatively attractive valuations, as the German court case challenges the ECB’s independence. One offset to this risk: The ECB may up the scale of its bond purchases in coming months, which would support peripherals and euro area credit. Over the strategic horizon, we already see a diminished case for nominal developed market bonds due to the market reaction and policy response to the outbreak. Yields have fallen close to lower bounds, reducing return expectations and the ballast properties that traditionally help nominal government bonds cushion portfolios against risk-off episodes. The picture may look even gloomier over coming years if supply chain changes pick up pace, monetary policy is more accommodative and inflation risk rises. The court ruling offers a glimpse of challenges to effective policy execution – and adds to reasons to be wary of nominal government bonds.
Past performance is not a reliable indicator of current or future results. It is not possible to invest directly in an index. Sources: BlackRock Investment Institute, with data from Refinitiv Datastream, May 2020. Notes: The two ends of the bars show the lowest and highest returns versus the end of 2019, and the dots represent year-to-date returns. Emerging market (EM), high yield and global corporate investment grade (IG) returns are denominated in U.S. dollars, and the rest in local currencies. Indexes or prices used are: spot Brent crude, MSCI USA Index, the ICE U.S. Dollar Index (DXY), MSCI Europe Index, Bank of America Merrill Lynch Global Broad Corporate Index, Bank of America Merrill Lynch Global High Yield Index, Datastream 10-year benchmark government bond (U.S. , German and Italy), MSCI Emerging Markets Index, spot gold and J.P. Morgan EMBI index.
Fiscal and monetary policy action to bridge the economic impact of the coronavirus has taken shape – and now the priorities are 1) policy execution to ensure households and businesses actually receive the pledged funding; and 2) avoiding policy fatigue before the shock has passed. Markets have been torn between optimism on the tentative re-opening of some economies and caution on the still grim economic data. The U.S. administration, meanwhile, is making a calculus between the perceived political benefits of being tough on China and the risk of renewed stock market volatility.
- Tuesday: U.S. NFIB Small Business Economic Trends survey; China, U.S. consumer price index
- Thursday: U.S. weekly initial jobless claims
- Friday: Univ. of Michigan surveys of consumers; U.S. retail sales, Empire State Manufacturing Survey, industrial production; China industrial output, retail sales; euro area flash estimate GDP
A trio of surveys in the U.S. – on small business, manufacturing and consumers – could provide important insights on the impact of the pandemic. Markets will watch out for any cracks in the financial system and elsewhere in the economy as virus infections climb. Data from China, including total social financing, could shed light on the recovery of the manufacturing and consumer sectors – or lack thereof – as the economy has cautiously re-opened.
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