Global Fixed Income Strategy May 2017

Monthly insights and updates from the Invesco Fixed Income team.

May 28, 2017 | Invesco Fixed Income

EZ does it after the French elections

Now, after the French presidential election, is a good time to take stock of eurozone (EZ) prospects, as markets move beyond politics to the economy, European Central Bank (ECB) policy and reform. The EZ economy is in a “Goldilocks” phase of good growth and low core inflation, despite recent upward pressure on headline inflation. We expect substantial slack to keep weighing on core inflation, enabling several more quarters of at- or above-trend growth before the output gap closes.

Even then, inflation may well remain low because structural reforms are needed to boost productivity and potential growth, particularly in France and Italy. Such reforms would initially boost unemployment, curbing wages and inflation. Absent reform, however, corporate capital expenditure and hiring are likely to be restrained and delayed, limiting demand-side inflation. Furthermore, real wage growth is already decelerating, which should limit consumption growth and inflation pressures.

As such, the ECB may start to gradually “normalize” monetary policy in the coming months – say with a modest deposit rate hike and/or a very gradual tapering of quantitative easing (QE) – but only to a limited extent, given the sizeable output gap and structural headwinds to self-sustaining growth and above-target inflation.

We therefore expect the euro and bond yields to rise only moderately in coming months, and expect EZ credit spreads to remain well supported. We also expect continued decent EZ growth, but low inflation combined with limited monetary policy normalization, to support global financial conditions.

The EZ economic cycle: robust growth but subdued core inflation
The cyclical EZ growth outlook remains robust, with the overall economy seeming to fire on all cylinders. Most of the components of our EZ “NowCast” growth model are pointing upward, and indeed, the balance of risks to the growth outlook is skewed toward upside surprises.1

Even so, we expect only very gradual and limited ECB monetary policy normalization, for several reasons. Core inflation is likely to remain subdued once commodity price shifts wash through headline inflation and the output gap will likely require several quarters of trend growth to close at the current pace.

EZ unemployment overall continues to decline, which is no doubt helping to support household consumption. However, labor market performance remains uneven across national economies and segments of the labor market. The EZ core continues to see robust demand for labor and low unemployment rates. But unemployment remains high in the periphery and among younger, less skilled workers. As in other developed markets, labor mobility, technology and offshoring are probably combining to hold back wage growth as a source of inflation pressure.

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