Chandler Bond Market Review

Europe’s Nascent Economic Recovery

After six quarters of declining gross domestic product in the euro zone, economic growth finally turned positive in the second quarter of 2013, marking the end of a long recession in the region. Several recent economic data points have also been indicative of improving economic conditions in Europe. Meanwhile, fears of a potential breakup in the euro zone which rattled the financial markets over the past few years have diminished significantly, due in large part to accommodation from the European Central Bank and stabilization in demand. It appears that market participants have become more complacent about Europe as tail risks from a European breakup have dissipated. Many investors are now looking to Europe for undervalued investment opportunities. However, Europe is not completely out of the woods in our view, as core structural economic issues have not been completely resolved and many of the peripheral countries continue to struggle.

Recent Euro Zone Economic Data

 

While economic data in the euro zone has improved, GDP growth in the region is still lagging behind growth in other parts of the world such as the United States and China. Moreover, improving economic data in the euro zone has also largely been fueled by gains in core nations such as Germany and France. Meanwhile, economic growth in many of the southern peripheral countries such as Cyprus, Greece, Italy, and Spain, has continued to contract and unemployment levels remain unfavorably high. The unemployment rates in Greece and Spain remain well over 20%. Many of the peripheral countries also continue to contend with very high government debt to GDP ratios. At the end of the first quarter, the sovereign debt to GDP ratios in Greece, Italy, Portugal and Ireland were each above 100%.

Government Debt Percent of GDP

 

European Central Bank (ECB) policymakers have made strides toward stabilizing the European economy and tackling the region’s debt crisis. They have lowered interest rates (the ECB’s benchmark interest rate currently stands at a record low of 0.5%, down from 4.25% in 2008) and provided cheap financing to euro zone banks through the Long-Term Refinancing Operations (LTRO), which launched in December 2011. However, governments are largely expected to maintain their austerity policies, in an effort to curtail their heavy sovereign debt loads. In our view, this means the euro zone is unlikely to see a significant jump in economic growth anytime soon. In addition, the ECB is unlikely to keep its key interest rate low for long, given that its primary mandate is to protect price stability (unlike the Federal Reserve’s dual mandate of maximizing employment and price stability). As such, we believe investment downside risks still remain and investors should be selective about their exposure to Europe.

We remain particularly cautious about many European banks, which are still working to implement stricter capital requirements. The euro zone is also still in the early stages of developing a banking union in which the ECB and national supervisory authorities will jointly assess the health of systemically important banks. European leaders are taking steps in the right direction, but structural reforms take time to implement.

Nevertheless, we believe improving economic conditions in Europe could be a tailwind for corporate earnings in the second half of 2013. Economists at BCA Research estimate that corporate operating earnings in the euro zone could rebound meaningfully by the end of this year. They believe the catalysts for improvement in corporate profits will be a decline in borrowing and labor costs, as well as a reduction in government fiscal austerity.

We believe earnings upside exists not only for European-based corporations, but also for U.S.-based multinationals. Whereas Europe has been a weak spot for many corporations (such as Ford, Staples, and Coca-Cola) over the past year, we believe improving economic fundamentals in Europe could contribute to positive earnings surprises for these companies in coming quarters.

 

-Shelly Henbest

VP, Credit Analyst

 

 

RISKS AND OTHER IMPORTANT CONSIDERATIONS

This report is provided for general information purposes only and should not be construed as specific legal, tax, or financial planning advice. All opinions and views constitute judgments or relevant information as of the date of writing and such information may become outdated or superseded at any time without notice. This report is not intended to constitute an offer, solicitation, recommendation or advice regarding any securities or investment strategy. This information should not be regarded by recipients as a substitute for the exercise of their own judgment. Fixed income investments are subject to interest, credit, and market risk. Interest rate risk: the value of fixed income investments will decline as interest rates rise. Credit risk: the possibility that the borrower may not be able to repay interest and principal. Low rated bonds generally have to pay higher interest rates to attract investors willing to take on greater risk. Market risk: the bond market in general could decline due to economic conditions,especially during periods of rising interest rates.

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