Europe's Recovery Masks Fragility, Pimco Warns Bond Investors

The euro area’s current economic performance masks persistent underlying fragility and imbalances, meaning investors should be wary of the region’s riskier sovereign bonds, according to Pacific Investment Management Co.

In a counterpoint to the current optimism about the strength of growth, Pimco Executive Vice President Nicola Mai said in a report that while “things look good over the cyclical horizon, investors shouldn’t be complacent about the long-term outlook.”

“The region is still far from resolving its existential challenges,” he said.

Many of those challenges are linked to the crisis that almost lead to the demise of the 19-nation currency bloc earlier this decade -- consistently low-inflation and high surpluses in countries such as Germany and the Netherlands, inconsistent economic reform, too little fiscal restraint in some high-deficit countries. and limited political will to change the situation.

While these aren’t an issue now -- and Pimco is optimistic on the near-term outlook -- it warns that they will “come to the fore when the region is next hit by an economic shock” and test the integrity of the region.

Though French President Emmanuel Macron is pushing for greater risk sharing that would help provide the euro area with counter-cyclical buffers in the next downturn, German Chancellor Angela Merkel’s ability to meet such an initiative may be limited.

“Don’t count on a Franco-German grand bargain,” Mai wrote. In Germany “the vision for Europe looks to be more of the same.”

Mai recommends bond investors focus on the most liquid sovereign markets when considering investing in riskier bonds.

“Our cyclical bullishness on the euro-zone outlook suggests that we could see further compression in Italian and Spanish spreads ahead. Our long-term caution, on the other hand, dissuades us from having a clear overweight stance in these assets. What’s more, medium-term uncertainty means we place a lot of value on liquidity, leaving our preferred peripheral sovereign exposures focused on larger issuers such as Italy and Spain.”

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