JPM_Europe Year Ahead 2019_watermark

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Mislav Matejka, CFA	Europe Equity Research
(44-20) 7134-9741	03 December 2018
[e-mail]

ECB president Draghi’s eight year term at the helm of the central bank ends in October 2019. As yet there is very little visibility on who his replacement might be.

Although it might seem reasonable to expect a German candidate to succeed Draghi—after all since 1999 we have had a Dutch, a French and an Italian president—the talk is that the Germans would prefer the presidency of the European Commission rather than the presidency of the ECB. It is important who replaces Draghi. Although ECB decisions are made by the 25 member governing council, the direction of the central bank is driven by the executive board and the president. Draghi was instrumental in developing the OMT instrument and in the central bank moving into asset purchases.

The outlook for politics

The political landscape in the region looks very uncertain as we look into 2019. The German political landscape has been changed dramatically by the collapse in support for the CDU/CSU and SPD in recent state elections. Merkel’s decision to step down as CDU party leader later this year marks the beginning of the end of the Merkel era, which has dominated German and Euro area politics since 2005. Although in principle Merkel can stay on as Chancellor until 2021, this may not happen. However, it would be difficult to replace her as Chancellor without an early election. Even aside from the pressure on Merkel from within her own party, the current coalition could collapse due to the SPD pulling out. A key date will be next September when the coalition treaty has scheduled a mid-term progress evaluation.

In addition to national fiscal developments, there is also the European Parliamentary elections next May. Populists are looking to do well, and indeed they are likely to. Excluding the UK, populist MEPs will likely go from 19.2% of the total in 2014 to 26.0% next year (Table 7). Many populists hope that a surge in support in the parliamentary elections will help to start moving the EU in a different direction. However this seems unlikely. Populists are not a coherent group, and even if they were they remain in a minority. And also, the direction of the EU is not set in the parliament but in the European Council. Populists would have to do a lot better in national parliamentary elections to dominate the Council.

Table 7: The evolution of populist seats in the European Parliament

		Populist Seats		Proportion of EP
	2009	2014	2019'	2009	2014	2019'
Germany	0	8	15	0.00	1.07	2.13
France	8	27	31	1.09	3.60	4.40
UK	15	24	N/A	2.04	3.20	N/A
Italy	9	22	45	1.22	2.93	6.38
Spain	0	5	10	0.00	0.67	1.42
Poland	15	22	24	2.04	2.93	3.40
Romania	0	0	0	0.00	0.00	0.00
Netherlands	4	4	10	0.54	0.53	1.42
Belgium	2	1	3	0.27	0.13	0.43
Czech republic	0	0	2	0.00	0.00	0.28
Greece	5	12	7	0.68	1.60	0.99
Hungary	14	12	12	1.90	1.60	1.70
Portugal	0	0	0	0.00	0.00	0.00
Bulgaria	2	1	2	0.27	0.13	0.28
Sweden	0	2	4	0.00	0.27	0.57
Austria	2	4	5	0.27	0.53	0.71
Denmark	3	5	3	0.41	0.67	0.43
Finland	1	2	1	0.14	0.27	0.14
Slovakia	1	0	3	0.14	0.00	0.43
Ireland	0	0	0	0.00	0.00	0.00
Lithuania	2	2	1	0.27	0.27	0.14
Latvia	1	1	2	0.14	0.13	0.28
Slovenia	0	0	0	0.00	0.00	0.00
Cyprus	0	0	0	0.00	0.00	0.00
Estonia	0	0	1	0.00	0.00	0.14
Luxembourg	0	0	0	0.00	0.00	0.00
Malta	0	0	0	0.00	0.00	0.00
Croatia	N/A	0	2	N/A	0.00	0.28
Total	84	154	183	11.41	20.51	25.96
Total ex. UK	69	130	183	10.39	19.17	25.96

Source: European Parliament, Domestic polling agencies, J.P. Morgan '2019 numbers are forecasts based on domestic polls

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Mislav Matejka, CFA (44-20) 7134-9741

[e-mail]

Gianluca SalfordAC

(44-20) 7134-1692 [e-mail]

Aditya Chordia

(44-20) 7134-2132 [e-mail]

This is an extract taken from ‘Global Fixed Income Markets 2019 Outlook: Aging but healthy cycle, synchronised normalization, short duration’, published on 21 November 2018

We forecast 10Y Bunds around 1.0% by year-end and tighter intra-EMU spreads

Europe Equity Research

03 December 2018

Euro Area Rates Outlook

2018 was a very disappointing year for the Euro area, with macro and political upsets unsurprisingly leaving German yields stuck in a range and intra-EMU spreads wider

The hurdle for 2019 to deliver something better is low

We forecast 10Y Bunds around 1.0% by year-end and tighter intra-EMU spreads

The forecast strikes a balance between optimistic baseline scenarios for most of the drivers and risks tilted to the downside

The key calls are on longevity of the US cycle, macro developments in the Euro area and the end game for the Italian government

End of net QE, change in personnel at the ECB, other political events should be less crucial

We recommend shorts in 10Y+ Germany, 2s/10s Germany and/or 3s/10s France steepeners to express a bearish duration view

Intra-EMU spreads should be traded tactically in 1H19

We recommend positive carry directionality-hedged 5s/10s or 5s/30s steepeners in Italy

Country-wise, we favour Portugal, Ireland as well as Austria and Finland

Euro area inflation: we advise longs only in 2H19 due to soft core inflation profile

Will 2019 be better than 2018? The hurdle is low

It might be unfair to say that 2018 was an unmitigated disaster for the Euro area but the list of positives only contains labour market developments (unemployment rate and wages measures). Other activity indicators showed a steady decline in real GDP growth and core inflation. Moreover, politics provided market unfriendly surprises, starting from of course Italian politics but also including loss of popularity for mainstream parties in Germany and France, and a change in government in Spain. It is, therefore, not surprising to see 10Y Bunds yields close to 35bp.

Our outlook for 2019 incorporates the expectation that some of the drivers that haunted us this year will take a more positive turn (Exhibits 1 & 2). We forecast 10Y Bund yields at 1.0% by the end of 2019 (0.65% by mid-year) and 10Y ItalyGermany spread at 225bp (but still at 300bp by the middle of the year). At year-end, our 10Y Bund forecast is 36bp higher than the forwards and 10Y Italy-Germany 124bp tighter.

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Mislav Matejka, CFA	Europe Equity Research
(44-20) 7134-9741	03 December 2018
[e-mail]

Exhibit 1: We expect the ECB to start tightening in 2019 and the market to expect more beyond next year, leading to higher rates

J.P. Morgan interest rate forecast; German benchmarks unless otherwise stated; %

	19-Nov	1Q19	2Q19	3Q19	4Q19	4Q19 v s.
						fw d (bp)
2Y	-0.59	-0.50	-0.45	-0.30	-0.15	21
5Y	-0.22	-0.05	0.05	0.30	0.45	39
10Y	0.37	0.55	0.65	0.90	1.00	36
30Y	1.04	1.20	1.25	1.40	1.45	33
2s/10s (bp)	96	105	110	120	115	15
10s/30s (bp)	67	65	60	50	45	-3

Exhibit 2: Pressure on Italy-Germany spreads to remain wide in the near term but to fade in 2H19 under the baseline scenario

J.P. Morgan forecast of 10Y EMU curve-adjusted spread to Germany*; bp

	19-Nov	1Q19	2Q19	3Q19	4Q19	4Q19
						v s. fw d
Austria	28	25	25	20	20	-10
Belgium	48	50	45	40	35	-17
Finland	27	30	25	20	20	-8
France	38	40	35	30	30	-11
Ireland	66	55	50	45	45	-26
Italy	319	325	300	240	225	-124
Netherlands	15	15	15	10	10	-6
Portugal	159	150	145	130	115	-61
Spain	128	120	115	110	100	-42
Wtd. peri. spread**	242	243	225	187	174	-91

*Adjusted for maturity mismatch by taking the difference in maturity matched swap spreads.

**Weighted peripheral spread computed against Germany for Ireland, Italy, Portugal and Spain (weighted by the size of their outstanding bond market).

Timing-wise, it is very possible that the first few months of 2019 might not deliver much joy to our medium-term views, with the only positives coming from an expected rebound in activity, a smooth transition from net QE to reinvestments and an agreement on Brexit. The views should gain more traction later in the year as the ECB lays the ground for rates tightening, as core inflation drifts up and as the balance of risk in Italy shifts to positive.

Our trading themes are:

Shorts in 10Y+ Germany, 2s/10s Germany and/or 3s/10s France steepeners to express a bearish duration view

Intra-EMU spreads should be traded tactically in 1H19 on expectation of sideways move

We recommend positive carry directionality-hedged steepeners in Italy initially and plan to move to intra-EMU tighteners later in the year

Country-wise, we favour Portugal, Ireland, respectively, on lack of political pressure and on valuations/Brexit respite, as well as Austria and Finland when compared to France and Germany

In the next few sections, we first discuss the main drivers of our call, followed by analysis of the German curve and intra-EMU spreads. We close with a separate section on Euro inflation-linked markets.

Drivers of our forecast

Exhibit 3 shows a summary of our thoughts on the most important market drivers in 2019 and implications for Euro area markets.

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Mislav Matejka, CFA	Europe Equity Research
(44-20) 7134-9741	03 December 2018
[e-mail]

Exhibit 3: A peculiar outlook: fairly sanguine baseline scenarios everywhere but most risks are tilted to the downside

J.P. Morgan views on market drivers for 2019 and their market implications;

Driver	Baseline view	Baseline impact	Risk skew
Activ ity	Strong bounce in 4Q18, solid 2019	Higher German y ields/tighter intra-	Limited dow nside risk to grow th forecast
		EMU spreads
Inflation	Core inflation rises to 1.4% by y ear end; solid w age	Higher German yields (later in the	Some dow nside risk that transmission from
	data	y ear)	w age to prices is delay ed further
ECB monetary policy	ECB hikes tw ice to bring depo to 0% by y ear end;	Higher German y ields	Significant risk of less hawkish ECB reaction
	change in ECB personnel with limited consequences		function
ECB: end of net QE	Modestly higher Bund y ields; intra-EMU spreads more	Modestly higher EGB y ields	Risk of higher German y ields and/or w ider intra-
	v olatile		EMU spreads
Politics: Italy	Cautious policy actions in 1H19; more market friendly	Higher German y ields/tighter intra-	Risk of unpredictable policy making
	gov ernment by the end of 2019	EMU spreads (later in the y ear)
Politics: Other Euro area	No significant change to the status quo	Higher German y ields/tighter intra-	Highest risks of market-unfriendly
		EMU spreads	dev elopments in Spain
Technicals	Mostly stable ratings in 2019	Modest	Dow nside for Italy if the macro outlook
			deteriorates
Ex ternal factors: Brex it	Withdraw al agreement ev entually signed off	Higher German y ields/tighter intra-	Ov erall negative impact on no deal a lot more
		EMU spreads	pow erful than positive impact of Brexit
			delay /second referendum
Ex ternal factors: US	US economy slow s, temporary w obbles are likely, but	Higher German y ields/tighter intra-	Risks that markets w ill be more nervous about
aged economic cy cle	ov erall concerns about recession are not increasing	EMU spreads	end of US cy cle
Ex ternal factors: US-	Third round of tariff on US imports from China; negativ e	Modestly low er German yields/w ider	Risk of less aggressive action
China trade tensions	impact on Chinese grow th contained	intra-EMU spreads

Activity: solid 2019 after a disappointing but not horrible 2018

This is a key call for EGBs. We believe that Euro area growth will resume abovepotential pace after the 3Q18 weakness, itself mostly driven by one-off-factors. Therefore, we forecast a strong rebound in 4Q18 (2.5%) and a solid 2019 with around 2% annualised quarterly GDP prints. Our 2019 GDP forecast is two tenths higher than consensus (1.9% vs. 1.7%) (Exhibit 4). We see limited downside risks to our 2019 activity outlook as we have already downgraded significantly the forecast for Italy.1 Consistent with this forecast the unemployment rate should continue to march lower, although at a slower pace compared to previous years.

Inflation: building blocks for higher core inflation in place

Euro area core inflation has been stuck in a fairly tight range over the past few years and has been one of the main factors keeping a lid on Bund yields. We believe that the building blocks of a pick-up in core inflation are more solid than in the past due to the reduction in the unemployment rate and increasingly evident wage pressures. However, given our expectation of the Euro area price Phillips curve flatter for longer to reflect the recent disappointment in the data,2 we expect core inflation to move broadly sideways until the summer of 2019 and then start moving gradually higher (Exhibit 5). The risk remains slightly to the downside if the transmission from wage to prices is delayed further.

1See Italy Sleepwalking into anemic 2019 growth, M. Protopapa, 8 November 2018.

2See Euro area Phillips curve Flatter for longer, R. Brun-Aguerre, 9 November 2018.

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Mislav Matejka, CFA	Europe Equity Research
(44-20) 7134-9741	03 December 2018
[e-mail]

Spread Targets and Positioning

In Table 1 below we set out our spread and return forecasts across the various segments of European credit markets for 2019. Our trading themes for the coming year are as follows:

CSPP eligible bonds will stay expensive.

Long-dated, higher-rated assets offer value.

Continue to trade up in rating.

Position for compression in Financials, with Subordinated Financials being the most attractive higher beta asset.

Fundamentals and technicals favour decompression in Non-Financials.

Europe is cheap to US.

Table 1: 2019 European Credit Spread and Return Forecasts

Asset	Index (Metric)	Current Spread	YE Forecast	Change	Total Return
Investment Grade Bonds (EUR)	iBoxx EUR Corp (Govt)	142	160	+18
Investment Grade Bonds (GBP)	iBoxx GBP Corp (Govt)	164	180	+16
High Yield Bonds (EUR)	iBoxx HY Non-Fin (Govt)	417	500	+83	2.0%
Investment Grade CDS (EUR)	iTraxx Main	70	85	+15
Investment Grade Financials CDS (EUR)	iTraxx Sen Fin	90	110	+20
High Yield CDS (EUR)	iTraxx Crossover	265*	335	+70
Leveraged Loans	S&P LCD ELLI				2.5%

Source: J P. Morgan. Spreads as at 12th November 2018. *Excluding AST M

CSPP eligible bonds will stay expensive

In our view, the end of the ECB CSPP is largely priced in, with spreads having already risen by 45bp this year (Figure 7). That said, it is notable that the differential between eligible and ineligible credit actually remains near the historical wides at 20bp, having traded largely flat for the past year (Figure 8).

However, in our view, this gap is likely to prove persistent for three reasons. First, the central bank will still own 20% of the eligible universe, which is naturally causing investors to be underweight the asset class compared with the benchmark. As a result, we think that they are hesitant to further reduce their exposure, which means there are relatively few marginal sellers.

Second, ineligible bonds are mostly from UK, US and EM issuers, and so traded 5 - 10bp wide to eligible bonds even before the asset purchase program started. In our view, UK assets should probably carry an even larger premium now considering the alarming risk of a ‘no deal’ Brexit scenario.

Finally, we think that the market has to discount the possibility that the central bank will have to restart quantitative easing if the economy is not actually ready to function without stimulus. It is perfectly imaginable that the slowdown in 3Q18 GDP growth to 0.6% q/q saar proves to be more persistent than our base case, or that the Italian political crisis spills over into a broader periphery funding crunch. Put simply, we think that eligible bonds have an embedded ‘CSPP put’, as the program is likely to be restarted in the next recession.

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