While we accept that a return to economic growth and greater fiscal union are necessary preconditions for an end to the euro crisis, we believe that the tail risk of an imminent ‘Eurogeddon’ event has been reduced, thanks to potential ECB intervention.
It is this tail-risk which has attached a safe haven premium to gilts. Outside this safe haven issue, much of the poor economic news is already well in the price and it would only take a small improvement to spook the market.
The mid-term UK political situation has become more unstable and thoughts are turning to a potential downgrade on UK sovereign debt. The main counter-argument to our view is that the ECB plan has done nothing to contain the euro crisis, and so gilts will retain their attraction for investors looking to minimise their euro exposure.
We are generally happy with the outlook for inflation over the coming 12 months, albeit with the caveat of food and energy price pressure in Q4. However, given the sheer scale of the monetary policy response in the UK over the past three years, the Bank of England’s apparent asymmetric attitude to the 2% CPI target and the fact that UK inflation has proved to be sticky, despite a very deep recession and the weakest recovery on record, the long-term outlook for inflation looks much less certain.
Given that break-even rates are so low, we think this offers an opportunity in index-linked debt, although we note the low level of real yields.
