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Note: we have split the EGB supply forecast from that of the UK, which we will update alongside the US following the UK.
Summary
- EU nations have published their draft budgets. The forecasts for growth and labour market developments across the three largest economies look too optimistic.
- By comparison, the deficits for 2023 have overshot expectations despite economies having broadly outperformed expectations.
- There are constitutional issues with the German budget. This could mean Germany ends up with a smaller actual deficit (inc. off-budget funds) for 2024, or that they simply shift amounts between funds to allow it.
- Ultimately, there is growing likelihood that Germany will need to abandon its balanced budget commitment to reform its economy.
- The Italian budget sees a balanced primary budget. Moody’s outlook upgrade is a positive, but interest cost is a high and growing concern.
- The French primary balance retains a strong deficit even with the assumption that subsidy spend will be decently cut. Issuance >€285bn is a high possibility.
- ECB discussions of ending PEPP reinvestments are very important – that would be bearish EGBs, particularly the periphery.
Market Implications
- We see value being long 10Y Bund vs 10Y BTP trade at 170bp, targeting 200bp, with a stop at 155bp.
- We continue to see value being long 10Y gilt vs 10Y OAT (FX-hedged)
Go to: Eurozone Supply Outlook | New Benchmark Predictions
The Outlook for 2023
Taking a look at 2023 European budgets, the real growth forecasts baked into the Italian and French budgets continue to look relatively accurate. At the same time, the German forecast has looked significantly out of touch with reality (Chart 1). The German 2024 outlook also looks overly optimistic, as too do the French and Italian ones.
The deficits for 2024 are now submitted to the EU, but there are a number of important factors to bear in mind as to why these deficits should be of concern:
- Nominal growth is key – it surprised to the upside in 2023, along with the labour market. That helped keep revenues high (Chart 3).
- European fiscal prudence is slipping. Despite better-than-expected economic performance in 2023, budget deficits were greater than expected (both in total, and excluding interest costs, Chart 4).
- Nominal growth loses a tailwind as inflation drops. The GDP deflator (difference between real and nominal growth) will be lower, making real-growth (forecasts for which look optimistic) more important.
- Higher yields will be a further headwind to balancing budgets. If the ECB does accelerate PEPP reinvestments ending, rates could rise again.
Eurozone Budgets
German Budget in Disarray on Court Decision
Germany is looking for a deficit of just 1.75% GDP, of which 1ppt is interest cost, leaving a primary deficit of just 0.75%. An apparent return to the ‘Schwarze Null’ debt brake school of fiscal prudence.
This improved balance is based on a 0.3ppt reduction in expenditure/GDP (primarily driven by a reduction in subsidy spend), alongside a 0.5ppt increase in revenue/GDP (on social contributions and production/import tax). The assumptions underpinning this better deficit are unclear – changes to policy have only added to the 2024 deficit – but that is not the biggest issue.
The biggest is that this meeting of regulatory obligations has little bearing on the reality of intended spend, which the last few years (through accounting magic) has allowed for significant spending firepower to be squirrelled away in off-budget funds.
The issue is partly an accounting one, partly a transparency one. Off-budget funds are incredibly opaque, and current budget rules (due to the use of emergency clauses in 2021 and 2022) mean that much of the money that has been earmarked to fill the funds will not count towards the official debt brake figures until the funds are repaid – i.e. 2031-2061[1].
[1] Had they not been filled via the budget escape clause, it would have hit the budget either: when payments are made from the funds (the case pre-2022) or when the moneys are first allocated to the funds (the case post-2022 rule change).
The main bulk of off-budget spending power is in Economic Stability Fund (ESF) and its offshoot, ESF-Energy (ESF-E):
- ESF – €52bn debt
- ESF-E – €30bn debt, €170bn in reserve (i.e., not spent).
- Armed forces fund (AFF): €100bn room to borrow, and
- The Climate Fund (KTF): €91bn reserve.
The German constitutional court has thrown a spanner into the works, ruling the repurposing of €60bn in COVID-era funds for the KTF as unlawful. This basically means the government’s €57bn ear-marked (but not included within their official budget) for climate spending in 2024 is in question.
The coalition will not want to abandon this spend, but to suspend the debt brake again would require the opposition CDU/CSU’s backing (very unlikely). More accounting wizardry is possible.
Short-Term Fudge, Medium-Term Drop the Debt Brake
The German coalition is adamant that the 2024 budget will pass as is. There are several ways they could fudge their way around this:
- Use what is left of the KTF (€31bn) before any further restrictions are implemented.
- Attempt to shift headroom from the ESF-E (which expires mid-2024 and will mostly go unspent) to the KTF.
- Attempt spending cuts to offset the shortfall.
- Tap EU monies (highly unlikely, given it’s higher cost than German debt, and would be politically embarrassing).
- Push for greater joint EU climate spending to unlock more for themselves (politically unpopular).
- Any combination of the above.
The bigger picture conclusion to take is that:
- Germans are not returning to the debt-brake.
- A balanced budget is nigh impossible if Germany is to successfully transition its economic model. The CDU may gain from a strict constitutional court in opposition, but when they (likely) win the next election, the problem will bite them too.
It is likely to mean increased criticism of the debt brake, and with it concern from the ECB of a more fiscally loose outlook (our base case). For EGBs, the market coming around to higher German issuance should keep Bund yields higher. With it, expect EGB spreads to widen mechanically.
YTD Federal revenues as of August totalled €274bn, 2% ahead of the Finanzagentur’s full year forecast for €392bn by year-end (YE). Expenditure was €344bn, 2% below the run rate for the Finanzagentur’s YE target of €476bn.
If this relationship continues at its current rate, the YE deficit could end up being below €70bn, versus initial expectations of c.€86bn. October issuance was around where we had expected, but there is now no real need for the Finanzagentur to issue any more (Chart 5). However, given the uncertainty around the 2024 budget, it could be possible to use some of the budgeted space to refill the KTF.
2024 issuance is likely to see issuance remain high, which QT will add to on the duration front next year.
France
Much like Germany, despite stronger economic performance in 2023 the primary and total deficits in France ended up larger than originally planned. The latest forecast puts 2023 primary deficit at 3.4% GDP (up 1ppt vs original budget assumption), while total deficit (including interest) sat at 5.1% (up 0.2ppt). Looking out to 2024, and the primary deficit is forecast to remain high at 2.4% GDP. Furthermore, this is on strong nominal and real growth assumptions, and the expectation that expenditure/GDP can drop 0.7ppt
In July, YTD French revenues continued to overshoot target, but at a decreasing rate (c.11%), down 4pp from July. Expenditure continues to overshoot by more (23%, unch. vs July). This trajectory looks set to overshoot even the AFT’s updated estimates for 2023 deficit.
Issuance so far this year has already totalled the €270bn the AFT had predicted. On this basis, they can afford to take the foot off the pedal into December. Next year looks likely to see issuance volumes remain elevated.
Given the assumptions of reduced spending, and the lofty nominal and real GDP growth assumed, we see strong possibilities for French deficit overshooting next year and our lean is that that more than the slated €285bn of capital market will be needed. That adds to our expectation that gilts can outperform OATs ahead, especially on an FX-hedged basis.
Italy
Italy managed to avoid a downgrade to junk last week from Moody’s, and instead got an upgraded outlook by the agency to neutral. This was a positive surprise for the country, coming on the back of the improved energy picture (gas supplies secured) and implementation of national recovery plan.
In our view, however, there remain a lot of headwinds to the nation’s finances, and if the ECB does end up discussing earlier PEPP end it could put them in a very difficult position.
Like the other EZ nations, Italy is relying on a very high nominal and real growth story next year, as well as very positive dynamics in expenditure/GDP (down 3ppt ex interest cost). Whether this is achievable at a time when the economy is slowing and rate hikes continue to bite is highly uncertain. To their credit, at least they are also forecasting a slide in revenues/GDP (down 1.6ppt), unlike in France and Germany.
Italy may be forecasting a balanced primary budget, but interest cost is increasingly becoming the main drag on compliance with EU rules longer-term. Upward momentum in EGB yields seems likely ahead. There will be greater generic EGB issuance, higher ECB rates (we do not believe they will cut as fast as the market is pricing) and a high chance that the ECB brings forward the end to PEPP reinvestments. The last should be a serious concern for markets, given it was the TPI’s introduction in 2022 that saw BTP/Bund spreads drop 40bp.
Right now, with 10Y BTP/Bund spread closing in on 160bp, the move seems stretched. It may not take much to see this unwind quickly. As such, we see value being short 10Y BTPs vs 10Y Bunds at 170bp, with a target for a widening out to 200bp, and a stop at 155bp.
Italian October issuance was very high on the back of the BTP Valore’s second issuance (first in June), which raised around €17bn. Italy has been on the forefront of tapping the domestic retail market of late, although the short-tenor of the debt (c.5Y) will ultimately weigh on its debt profile. There is little by way of required supply into the end of the year, but we expect 2024 issuance will be increased, so they may want to get ahead of this.
Estimating New Benchmarks This Year
Germany is due a new 5Y imminently, we expect they will wait until January to syndicate a new benchmark. The current benchmark (OBL 2.4 10/19/28) has €26bn outstanding. and 10Y (DBR 2.6 08/15/33) benchmarks. The 10Y can probably wait until January, but with €7.5bn currently scheduled for the 5Y in Q4, there seems to be a high chance that a new benchmark 5Y there may be syndicated before YE.
France’s benchmark 3Y (FRTR 0 02/25/25) still has €32bn outstanding, and is due a replacement. We expect they will wait until next January to issue a new benchmark.
As we had warned previously, Italy issued new 10Y and 7Y benchmarks in September. Now, we see the 5Y space needing a new benchmark, given that the current one (BTPS 0 ½ 02/01/26) is now at €20bn outstanding. In line with this, the Tesoro has marked a new one (Jan-29) to be issued in Q4. We expect this will come in November.
Henry Occleston is a Strategist, who focuses on European markets. Formerly, he worked in European credit and rates strategy at Mizuho Bank, and market strategy at Lloyds Bank.