Credit Spreads Suggest That Europe's Economy Could Be Turning A Corner

Mario Draghi, the President of the European Central Bank. (Photo: European Parliament)

Markets starting to like Italian debt again

Surveys say Chinese exports picking back up

If EU turns back on, will East Coast freight rebound?

There are plenty of reasons to be pessimistic about the European Union's (EU) economy and its potential contribution to U.S. growth in 2019. On March 7, European Central Bank (ECB) President Mario Draghi said that Eurozone gross domestic product (GDP) would only grow 1.1 percent this year, revising down about 60 basis points (bps) from where forecasts were three months ago.

"The risks surrounding the euro area growth outlook are still tilted to the downside," Draghi told journalists on March 7.

The EU's Manufacturing Purchasing Manager's Index (PMI) also dropped below 50 to 49.3 in February, the sharpest contraction in the European manufacturing sector since June 2013.

Still, global central banks – including the Federal Reserve – have turned dovish, either pausing interest rate increases or lowering rates in a synchronized way, reassuring investors that policymakers recognize the need for stimulus. This Wednesday, the Fed will meet again and Chairman Jerome Powell will speak to the press; the Fed is widely expected to keep rates where they are at.

Markets have acknowledged central banks' shift to more accommodative policies by returning to risk assets like equities and the higher-yielding parts of the debt market. European junk bond yields have fallen more than 100 basis points this year, and the healthy appetite for Greece's first debt issuance in nine years suggests that markets like sovereign debt from countries on the periphery of the Eurozone, too.

One of the most widely followed data points on investor sentiment toward Europe is the spread between Italian 10-year bond yields and 10-year German bund (bond) yields. German bonds are considered a low-risk asset similar to U.S. Treasuries. Germany is far more fiscally disciplined than Italy, with a debt-to-GDP of approximately 60 percent compared to Italy's 132 percent. Italy's debt is rated BBB by Fitch and S&P, and rated Baa3 by Moody's: in all three cases Italy's bonds are at or near the bottom of what is considered "investment grade."

Italian bonds always offer higher yields than German bonds. When the spread between Italian and German 10-year yields tightens, that means that for whatever reason, the Italian debt is becoming more attractive relative to German debt. Investors tend to buy riskier assets when they are more confident that the economy will expand and that debt issuers who may be under some financial pressure will have no trouble meeting their obligations.

(Chart: Investing.com)

The spread has narrowed by more than 50 bps since last month to 234 bps and is down 100 bps from a recent high of 334 bps on November 20, during the fourth quarter's mini-panic and flight from risk.

There has been some more-positive-than-usual political news out of Italy that has helped its bonds rally. A coalition government formed last spring by the right wing populist parties Five Star Movement and The League currently control Italy's Parliament. Both parties are Euro-skeptic, which bondholders don't like because they perceive a risk that under such a coalition, Italy's chances of leaving the European Union and paying its creditors in lira are somewhat higher. However, both the Five Star Movement and The League have lost support in recent polls and may have passed their high-water mark, a theory that cheered markets.

But it's not just the minutiae of Italian parliamentary politics that has investors ready to move money into European risk assets. Across the board, European equities have done quite well year-to-date: the EURO STOXX 50, an index containing the largest, most liquid European blue chip names, has returned 12.82 percent so far in 2019.

"Right now feels like pretty bad times in Europe," said FreightWaves Chief Economist Ibrahiim Bayaan. "Part of this is Brexit-related and part of it is trade-related, both in terms of trade policy and in slowing growth in some of the key markets. But the easy money stance taken by ECB makes it less likely that the region overall falls into recession this year. There are still some potential shocks out there that could push it into contraction though, like the U.S. ramping up tariffs on the EU or a messier Brexit process. Absent those shocks, the EU probably manages to grow around 1.0 percent this year or slightly below."

Why does this matter? The health of the European economy matters to the United States transportation and logistics industry because the trade between the U.S. and the EU was valued at $806 billion last year. It's an important relationship between two of the planet's three largest economies. In fact, the United States' trade deficit with the EU grew 17 percent last year to a new record, a statistic that could attract unfavorable attention from the Trump administration. Further barriers to trade, like new tariffs, could threaten to quash the green shoots some observers are seeing in Europe.

European exports to the United States move one of two ways – by air or by sea. The chart below displays air cargo rates in U.S. dollars from Frankfurt to North America (AIRUSD.FRANOA, white line) and Freightos' Baltic Index container rates from Europe to the North American East Coast (FBX.ENAE, green line).

(Chart: FreightWaves SONAR)

Although air cargo rates from Europe to North America are down year-over-year, container prices from Europe to East Coast ports are still above where they were at in March 2018, almost $160 more per forty-foot box. Expect air cargo rates to come down as flights, and belly cargo capacity, are added to Transatlantic services to accommodate tourists beginning in May.

One more reason to think Europe's economy may pick back up is that the EU's PMI closely tracks the China PMI Composite New Export Orders; when China's manufacturers report that they've received an increasing amount of export orders, that's a sign that new European data will be strong on the demand side. China's PMI for exports has picked up significantly, Morgan Stanley's Graham Secker pointed out in a March 11 note.

"In a recent report, we highlighted that the China PMI new export orders series leads the euro area PMI closely by about three months, while China credit growth tends to be a solid predictor of Morgan Stanley's European EPS growth lead indicator," Secker wrote. "Perhaps most striking of all, we found that European banks' relative performance has correlated more closely with Chinese bond yields than European bond yields over the last five years! Hence our bullish call on China suggests a better outcome for Europe in the months ahead."

If, despite the U.S. trade deficit with the EU, the two economies maintain their customary high-volume and high-value trade relationship, and Europe is able to break above 1 percent growth in 2019, freight volumes on the U.S. East Coast start to look interesting again.

Year-to-date, Los Angeles and Long Beach have been the most active ports – they're always the largest by volume, but now they have a larger market share than even last year. The frenetic drayage and trucking activity in Southern California has been in large part due to tariff pull-forward, clogged warehouses and spotty intermodal service. If the East Coast lights up, though, it will be on a resurgent Europe.

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