Multi-asset allocation views: Uncertainty clouds the outlook for European assets

Sunil Krishnan considers whether Europe can break out of its economic malaise and the factors investors should watch out for in 2020.

1 minute read

Given Europe’s challenging economic backdrop at the turn of the year, we remain underweight euros, using the currency to fund other positions. And while we are underweight ten-year German bunds, we have long positions in ten-year Italian bonds: with negative yields persisting in Germany (-0.248 per cent, as of 22 January), it is hard to see value in bunds, while Italian debt looks more attractive despite the political uncertainty (1.408 per cent, as of 22 January).

The handover of European Central Bank (ECB) leadership from Mario Draghi to Christine Lagarde at the end of last year has created an element of uncertainty. However, in our view this isn’t in itself enough to lead to an immediate change in policy. In fact, Mario Draghi ensured he left with a clear and transparent roadmap for euro zone monetary policy, including the agreement to begin the new asset purchasing programme and guidance that cash rates would likely not rise in 2020.

In that regard, the euro zone is in a position of continuity through change. Additionally, economic conditions don’t currently support a debate for tighter policy, with weak manufacturing activity – including in Germany, the region’s largest economy.

Figure 1: European manufacturing has struggled
European manufacturing has struggled
Source: PMI surveys, Aviva Investors, as of 31 December 2019

Therefore, although the euro is attractively valued in purchasing-power terms, it has remained one of the poorest among major currencies in terms of interest-rate differentials and economic surprises. Major currencies, particularly the US dollar and Japanese yen which also have risk-hedging properties, look more attractive.

Figure 2: 3-month interbank interest rates (%)
3-month interbank interest rates (%)
Source: Bloomberg, as of 15 January 2020

Nonetheless, the ECB’s stance provides support for all the euro zone’s bond markets, thanks to both the asset purchasing programme and current cash rates. However, this support is more limited for German bunds given the low yields already on offer as well as the limits to how much German debt the ECB can buy. In contrast, weaker economies like Italy will be bigger beneficiaries of ECB policy.

How can these factors change?

Firstly, the ECB has appealed to national governments to consider using fiscal stimulus more aggressively to support the region’s economies. We expect Christine Lagarde, as a former finance minister, to maintain this pressure. Any sign of synchronised fiscal stimulus in the euro zone could change the outlook, in particular for the currency, although economic coordination in the area remains elusive. An example of this difficulty can be seen in proposed enhancements to cross-border financial stability, which have recently been postponed until June 2020.

The other risk to using euros to fund other positions is if the euro becomes a consensus funding currency – like the Japanese yen has been for several decades. This can create the risk of crowded trades and lead to violent moves in the market. We are monitoring position indicators closely.

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