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Draghi still ruling on the iron throne (for now)

With his reign drawing closer to a conclusion and proffering the potential for a dovish turn, markets are none the wiser as to who will emerge as the next ruler in Frankfurt.

In a holiday-shortened week there was little new data to drive price action in markets, with bonds and currencies trading in relatively narrow ranges, consolidating some of the moves seen in the past several weeks.

Highlights from slim data pickings

Robust Chinese figures for industrial production and retail sales gave further confirmation of a growth rebound, though at the same time suggested that monetary authorities in Beijing could stop adding further stimulus, with the economy already having benefited from prior policy action.

Better PMI data in Europe also supported sentiment, though the region continues to underperform, relatively speaking, with manufacturing remaining notably soft across the continent.

We believe that a better global outlook can support demand in the eurozone, yet the ECB will need to remain on a dovish path for the months to come, with inflation stubbornly below target and rates trapped below zero for a seemingly indeterminable period.

In the US, economic conditions remain supportive in our view and, following the growth scare stories being reported just a few weeks ago, we would observe that Q1 GDP growth now seems likely to exceed 2.0% when the data is released later in the month, based on the most recent Nowcast estimates.

Even though Q1 was a disappointing quarter, impacted by the government shutdown and negative seasonal effects (which have seen Q1 GDP average just 1.5% over the past five years, when Q2 growth prints have averaged 3.6%), we believe that growth over 2019 as a whole can exceed 2.5%, with above-trend growth continuing to push the jobless rate even lower.

US rates have re-priced meaningfully in the past several weeks as recession fears are priced out, yet rates markets continue to discount monetary easing later this year and into 2020 when this currently appears to have little merit or justification.

US bank earnings have highlighted an impact on net interest margins from yield curve flattening and, with the Federal Reserve signalling a tolerance to allow inflation to rise before needing to act to raise rates again, we could see how this biases the yield curve steeper over time and for inflation breakevens to move wider.

However, for this to come about, we believe there will need to be some evidence of a stirring in price pressures and for the time being these remain muted and well contained.

Yet if equities move through their highs and global central banks are easing financial conditions just at a time when the growth outlook is starting to improve, it is possible that animal spirits push in this direction over the months ahead.

UK MPs retreat to convalesce

In the UK, in the short term, Brexit fatigue has seen a lot of MPs disappear on holidays, having pushed the can down the road. For now, little seems to be getting done and there is a sense of drift for the next week or two.

Over the next month, we expect a renewed push by May to build cross-party consensus in talks with Labour and even test if there is support for a softer Brexit (customs union type of outcome). We remain pessimistic that this will lead to an agreed conclusion.

It then seems that a dire showing by the Tories at the European elections could serve as a catalyst to jettison May (convince her to resign if they come in third or fourth place) and replace her with more of a Eurosceptic leader.

This could then see the possibility of elections in our view (if Labour/Corbyn are also perceived to be in disarray), in order for a new leader to secure a mandate to deliver the Brexit they would like to push through without needing to rely on support from the DUP or remainers within the Tory party.

This in turn could potentially see the UK veer either towards a Labour coalition government and a possible second referendum on the one hand, or a Tory hard Brexit government on the other hand, come October.

The other narrative becoming clearer to us, is that the rest of the EU is now completely bored of/frustrated by Brexit dragging on. This means that there is a much lower probability of an extension beyond 31 October, unless a change of government has occurred and a second referendum has been planned by this point.

Elsewhere in Europe…

Italian policymakers have highlighted that weak growth will likely lead to an overshoot of the budget deficit target. On the face of it, this may seem like cause for concern, though we feel that is Italexit fears that could see BTPs underperform and these seem very remote at present, in our opinion.

The Italian debt-to-GDP level remains broadly stable with Italy still running a material primary surplus. This should serve to limit the risks of a credit rating downgrade.

Consequently, periphery risk continues to stand out as cheap on a relative value basis, with Italy trading at a spread 50% wider than an equally weighted average of a combined basket of Brazil, Mexico and Russia.

Turkey: A cause for concern

Emerging markets have performed relatively well over the past month, yet we are concerned that Turkey is set for further weakness, should the delivery of Russian S400 missile systems lead to US sanctions being imposed in the weeks ahead.

This could also impact Turkey’s ability to access IMF assistance, as we believe it is increasingly likely to need to do so in the months to come.

As a European economy, weakness in Turkey is another factor that could be a negative for the eurozone, but we continue to believe that there will be little impact on European banks given that subsidiaries are locally capitalised, such that in extremis any exposures to credit deterioration can be contained.

Looking ahead

The Easter break creates a bit of a hiatus with investors away from their desks. However, with April only halfway through, we sense that where investors have pushed into owning more duration in the past few weeks, a further reversal could be due.

At the same time, we see incoming data as broadly supportive for risk assets and this should continue to help spreads.

We continue to see more value in sovereigns than corporates, even if heavy net issuance does seem to be finding increased investor demand – at least in the case of the eurozone, where hunger for yield remains a theme.

Yield-chasing may be helped by central banks, should Draghi allude to the possibility of restarting asset purchase if conditions warrant this as a follow-up step to the TLTRO extension and a likely introduction of deposit tiering in the weeks to come.

In this context, Draghi may end his term in office having pivoted in a dovish direction. As for his successor, we are still none the wiser as to who will be sitting on the ‘iron throne’ in Frankfurt at the conclusion of his final season.