In our H1-2015 Credit Outlook report issued six months ago, we had clearly portrayed our concerns about slowflation in the Eurozone on the back of a sliding price of oil and low growth expectations. Back then, we had mentioned the following points:

* The worry of “low inflation” and possibly deflation given the continuing slide in the price of oil remains most concerning,

* The key theme for 2015 is expected to be the decoupling of the US from the rest of the world.

* In the Euro Area the low interest rate environment and the use of monetary easing to propel economic activity, lower unemployment data and subsequently prices going forward is expected to be at the forefront of investors’ minds, as policy makers scramble to kick-start economies. The accommodative stance is expected to continue to provide support for financial assets.

* Another key theme we expect to feature in 2015 is volatility. For most of its part, 2014 was a somewhat complacent one in financial markets where volatility was historically low on average. Exogenous risks are expected to impact the market with bouts of volatility amid an uncertain outcome.

* QE speculation building up in Europe

In terms of market events, pretty much all of the above-mentioned expected scenarios unfolded, which has kept many European investors in awe and on edge as to what would be the next trigger which could impede the European growth recovery story. Low inflation rates, the ongoing Greek saga, announcement of QE and implementation thereafter, record low yields were the major themes which characterised most of the first half of the year. During May and June, a sharp selloff in IG on the back of improving economic data and increase in year-end inflationary forecasts by the ECB, coupled with technical factors at play propelled negative real yields higher back into positive territory.

The ongoing Greek impasse has pretty much weighed on investor, for most of the past 6 months, most notably May and June, whilst on the other hand, the famous QE announcement by the ECB on 22 January 2015 added this feel-good factor in capital markets, both credit and equity. And this feel-good factor was also filtered into the European consumer. Economic activity picked up, consumer lending registered upticks, business and consumer confidence were on the rise and fears of a deflationary scenario abated towards the May and June as price pressures were no longer in the red.

But on the economic front, not everything was rosy, and headline news at times seemed to drive investor sentiment with little importance given to key details, and the so called reading between the lines or reading between the numbers to be precise. A case in point was the June ECB press conference by President Mario Draghi whereby markets interpreted the tone of the speech as hawkish. However, the press release portrayed a more dovish scenario than what was the market first digested, namely the following:

* Risks surrounding the economic outlook for the euro area remain to the downside

* The dynamics of loans to non-financial corporations remains subdued

* “Strengthening and broadening” of economic recovery tone dropped to just “broadening” as ECB had expected stronger figures, as there has been an evident loss of momentum

* Inflation came below ECB’s expectations (albeit above market expectations), reinforcing its stance to at least see out QE in full till September 2016

Now with markets fully focused on the July 5 Greek referendum, announced over the weekend, it has become increasingly apparent that sovereign credit risk has pretty much moved out of the limelight and market risk is the order of the day, dictating sovereign spread direction. We do not view the ECB as being a real threat to the market as its policies and purchases are known facts and appear to be priced in current valuations. The Greece factor and elections in certain countries in Europe however remain threatening. And this only means that spread direction will not only be driven by the large volatility witnessed in the Bund but by also major peripheral macro or credit news.

Mark Vella is Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt .The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.  

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