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All good for Europe economy? Not really, says Pimco’s Nicola Mai

EurozoneThe Eurozone economic recovery is in full swing with 2017 growth likely to have reached 2.3% - but investors should remain vigilant about underlying fragility, asset manager Pimco warned.

In a note to investors, Nicola Mai, portfolio manager and head of sovereign credit research at the firm, said Pimco had a “cyclically bullish” stance on the Eurozone, but is placing value on liquidity due to a medium term caution.

The region’s upturn is synchronised and has further to run with growth heading for 2%-2.5% this year, Mai said.

What’s more, economies such as Ireland’s are recovering and even Greece is showing signs of healing.

Yet despite the strong upturn, inflation in the region remains depressed, with core inflation hovering close to 1% year over year, warned Mai in the note entitled ‘Eurozone Outlook: Economic Growth Masks Underlying Fragility’.

Mai said European Central Bank (ECB) asset purchases will be tapered from this month, and will probably stop altogether by the end of the year, but policy rates are likely to remain unchanged until around the middle of 2019. This strong stimulative stance should continue to support cyclical growth momentum in the region, he added.

There has also been a downturn in political risk. The French and Dutch elections in 2017 delivered moderate governments, while coalition-building talks are happening in Germany, meaning there is unlikely to be a significant change in the political status quo. Even EU anti-establishment parties have moderated their stances recently.

But the Mai said that despite the containment of political risks over the cyclical horizon existential challenges remain unresolved.

For example, there is structurally low inflation in Germany and a need for several countries to disinflate and recover competitiveness with the region’s largest country. These factors pose challenges to the ability of the public and private sector to deleverage, something that is necessary across the region, Mai said.

Also, there needs to be a commitment to macro convergence policies, but instead of this there is fragmentation in Europe’s capital markets with no true banking union or common deposit insurance system, Mai said.

The lack of appropriate macro convergence policies or fiscal stabilisation mechanisms has so far been filled by the ECB. By keeping rates low, and purchasing bonds of struggling eurozone countries, the ECB has acted as a de facto lender of last resort (LOLR) for sovereigns.

“However the ECB is at best an imperfect LOLR” said Mai.

Cyclical bullishness versus medium-term fragility means Pimco is “fairly neutral” on eurozone peripheral debt. Yields on Italian sovereign bonds are much less attractive than they were in recent years, but still offer a decent source of carry in today’s tight valuation world, Mai said.

The asset manager said that although its “cyclical bullishness” on the eurozone outlook suggested further compression in Italian and Spanish spreads, Pimco’s longer-term caution means it won’t overweight these assets.

Mai concluded that medium-term uncertainty means the firm places a lot of value on liquidity.

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