Disappointments across the board today in European Purchasing Manager Indexes has added strength to the argument for further easing from the European Central Bank in coming months. The Eurozone Composite PMI undershot its modest 52.2 target coming in at just 51.5; the Services PMI was in-line but the Manufacturing figure was just 46.4, representing an even greater contraction (anything below 50) than the 47.7 forecasted. Germany’s Manufacturing PMI figure was particularly bad at 43.1, versus expectations of 45.2, on a par with levels last seen in the 2012 European Debt Crisis and, prior to that, the Global Financial Crisis (where levels further plunged to the low 30s for the first half of 2009). Principal Economist at IHS Markit and author of this particular index, Phil Smith opined that “The health of German manufacturing went from bad to worse in July”.
The manufacturing contraction in the wake of the Global Financial Crisis was deep but lasted (only) 14 months, whereas for 21 months surrounding the European Debt Crisis the figure was persistently between 45 and 50 (with the odd month a fraction above or below this range). This particular PMI figure has steadily, and then more recently sharply, fallen from the mid-60s ending 2017 to the last 7 contractionary readings, the last 5 deeply so, being at or below 45.
Probabilities of a cut from the ECB next meeting are now close to 50/50 with a 90% implied probability of a cut (or multiple cuts) before the year is out; Bloomberg now calling ECB easing “simply a question of when”. But beyond further policy rate cuts, there is a range of further measures that are not off the table but simply have a higher degree of either technical or political headwinds to implement. At the high end for both technical and political constraints are all the forms of so-called “helicopter money” which we only contrive to expect after both further economic deterioration and exhaustion of all the more palatable options. Other more viable options include: resuming quantitative easing which would be only modestly challenging on both fronts, adjusting the capital key requirements to allow a higher proportion of stimulus to flow to peripheral Europe would be simple technically but remains a hard sell in some countries politically; following this might be new asset purchasing programmes in both equities and exchange traded funds but would raise challenges on both fronts; but perhaps this is still preferable to ECB purchases of unsecured bank debt.
Adding such policy uncertainty to economic uncertainty as well as volatile market sentiment makes it particularly difficult to estimate how they will all play out in aggregate. So although the European Central Bank may not have exhausted its policy arsenal we remain convinced that both negative-yielding core and low-yielding peripheral European sovereign credit offer weak risk-adjusted returns. The capital gains that have kept investors in the black in the months and years since the Eurozone Crisis are not sustainable, with this market now facing the dilemma of prolonged low/negative returns or a retraction of recent gains. We believe an overall positioning in highly rated investment-grade credit twinned with a margin of protection - via value screening for above-average spreads for given duration and rating buckets – helps make a bond portfolio more resilient to bouts of volatility whilst maintaining a pickup in yield in the meantime.