The Global Markets Weekly – 5/18/18

Posted May 21, 2018 by rvillareal

Eurozone Fiscal Outlook Back in Focus

Investors were reminded this week that underlying fiscal tensions and populist sentiment in Europe are still with us, despite having been pushed onto the backburner in recent years as growth has improved. The coalition that emerged from the Italian election in March, the Five Star Movement plus League, jolted markets as its program began to take firmer shape this week. It first included language that sought to write off debt held at the ECB as a result of QE. That was a red herring (wishing for a €250B writeoff wouldn’t make it so), later softened to just excluding that debt from the country’s debt to GDP ratio, and by week’s end to its omission entirely.

That may have been the early headline-grabber, but the bigger underlying message speaks to a divergence with the core, with a raft of populist spending measures on the table that would alter the country’s fiscal trajectory. Rolling back prior adjustments to pensions, boosting spending, cutting taxes, introducing a guaranteed income, varying degrees of wanting to take a fresh look at EU treaties, and more, are all reasons for the bond market and banking sector to take note even if there are hurdles to enactment. Separating the wheat from the chaff on the policy front has been difficult in Europe and the U.S. recently, with serious proposals mixed in with other messaging, aiming to persuade voters as much (or more) as actually drive policy.

Developments were worth about a 30 bps widening in the BTP 10yr spread to German bunds in two days (to 160 bps), still well shy of a 400-500 bps spread in the depths of the Eurozone crisis six to seven years ago. At some level, a loosening of fiscal policies is appropriate for the region as unemployment and discontent remain high in a number of peripheral countries. However, divergence with the frugal core–Germany–may become more pronounced in both policy and spreads. Issuance and debt levels in the safest of European paper will be diminishing over time, suggesting that even if not imminent, investors will demand more compensation over time, even if the ECB remains active. Integration efforts in the Eurozone are already challenging enough, and times are good.

This week brings a set of Eurozone PMI updates that will help determine whether growth and monetary policy in the common currency bloc is continuing to soften within a better trend, or firming up after the harsh weather earlier this year. April results saw a fourth consecutive diminishing in the breadth of manufacturing expansion, and third monthly decline in services.

Coming Week’s Key Indicators and Events

[private]5-18us gmw_0518[/private]