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2017 funding need expected to be €8.5B despite sufficient cash reserves
Irish bonds weathered all storms in 2016, but could become more vulnerable
ECB didn’t raise PSPP “issuer limit”, taking away “buyer of last resort”
Strong economic performance, but Brexit clouds immediate outlook
An improving jobs picture is a strongly positive picture
Rising house prices reflect “macro” gains and sectoral strains
Healthier public finances will help, but the policy focus is shifting slightly
Irish bonds traded with a clear pattern in 2016: every uncertainty-related event triggered spread widening in the run-up. However, whatever the outcome (positive or negative), investors used this weakness to “buy the dip”. It happened after the Irish elections, around the time of the British EU-referendum, following the unexpected election victory by Donald Trump and after the latest ECB’s policy meeting where the ECB didn’t raise the PSPP issuer limit but adapted other modalities which don’t benefit Ireland.
Strong fundamentals in terms of underlying growth and improving public finances as well as an understanding of the importance of ECB purchases on price trends in a comparatively small and sometimes not perfectly liquid Irish bond markets convinced investors of the attractiveness of maintainining an Irish element in their portfolios.
We hold our view that at current levels, EMU government bonds in general remain expensive. From a relative point of view, Ireland reconnected with the EMU “semi-core” (Belgium/France/Slovakia). The 10-yr yield differential between Belgium and Ireland for example trades on average around 20-30 bps since the end of last year. The coming year could see a little more volatility as the prospect of continuously favorable Irish debt dynamics is weighed against the potential impact of Brexit and the reduced role of ECB purchases in the market.
In 2016, NTMA issued €8.25B of long term bonds via one syndication and regular tap auctions, compared to an official funding target of €6-10B. At the start of the year, the NTMA launched a new 10-yr benchmark (€3B 1% May2026).
In 2017, we expect Ireland’s funding need to be around €8.5B, consisting of a €6.4B bond redemption (5.5% Oct2017) and a exchequer borrowing budget deficit of about €2.1B. NTMA estimates that its cash reserves will be around €7.5B by the end of the year, so actually Ireland is nearly fully funded for 2017! Also in 2018, the funding need is expected to be low, with again only one bond redemption (€9.26B Oct2018). These are favourable conditions to start preparing for the next “funding cliff” in the 2019-2020period when a mix of Irish bonds and bilateral loans come due (see graph). Against this favourable backdrop, the NTMA has indicated that it will issue between €9 and €13 billion of long term bonds in 2017. At the margin, issuance towards the upper end of this range may be favoured given current historically low funding costs and the incremental leeway this would provide for additional ECB purchases.
A new 10-yr syndicated benchmark is possible given that there are only EFSM loans maturing in 2027. NTMA will probably prefer an even longer maturity (eg 2032 or 2037) as it would fit even in the Irish redemption profile (see graph) and as it would fit in the Irish Treasury’s strategy to lengthen the average maturity of outstanding debt. Currently, that metric stands above 11 years, way above EMU average.
Under its Public Sector Purchases Programme, the ECB bought €17.9B Irish bonds up until the end of November. The weighted average maturity of the ECB’s current Irish bond portfolio is 9.19 years. Since the ECB stepped up monthly asset purchases from €60B/month to €80B/month in April, the average monthly volume of Irish government bond purchases increased as well, from €0.77B/month to €0.99B/monthTthe current pace of purchases can’’t be sustained much longer and certainly couldn’t continue until the scheduled end of the , of the PSPP programme in December 2017. That’s because Ireland is about to hit the issuer limit” (33%) which refers to the maximum share of an issuer’s outstanding securities that the ECB is prepared to buy. This limit is a means to safeguard market functioning of price formation as well as to mitigate the risk of the ECB becoming a dominant creditor of euro area governments. Without taking into account Irish bonds in the SMP-portfolio, the ECB already has €37.9B Irish bonds in portfolio. The other €20B are a legacy from the restructuring of the Irish promissory notes. Compared with the total amount of outstanding Irish debt (about €122B), the ECB holds slightly over 31%. If the central bank continues buying at the current pace, they’ll hit the issuer limit by the end of February next year. Some leeway may be provided by NTMA issuance that could allow purchases to continue at about 50% of the recent pace.Therefore we expect a significant slowing down in purchases to equally spread the remainder of the amount over 13 months). This reduction in the scale of purchases by the buyer of last(and possibly first) resort makes Irish bonds again more vulnerable to external events.
In February, Fitch upgraded the Irish A- rating (positive outlook) to A (stable outlook). Fitch justified the upgrade by an improvement in debt dynamics, reflecting the combination of strong growth and a return to a primary budget surplus. In May, Moody’s followed the example by raising the Irish rating to A3 from Baa1 with a positive outlook. Moody’s also cited the rapid improvement of the government’s public finances as well as the political deal reached following the elections. S&P, the third big rating agency, rates Ireland at A+ (stable outlook).
2016 marks the fourth calendar year of positive growth in both Irish GDP and employment and, as a result, the Irish economy looks to be on a solid and sustained path to recovery. This is expected to continue in 2017 and beyond but there is a fair measure of uncertainty and caution as to what the year ahead might bring in terms of potentially important headwinds to growth.
In one sense, this caution merely reflects the particularly open nature of the Irish economy in the context of a range of global challenges. Among the more important are possibly significant changes to US fiscal and monetary policy settings as well as ongoing concerns about the health of the Euro area economy and its financial sector that might be amplified by a number of key elections in some key EU States. However, the most obvious development from an Irish perspective is the UK’s declared intention to trigger the start of the Article 50 process leading to its exit from the EU early next year.
In an important respect, Brexit is already well underway from an Irish standpoint. A substantial drop in the value of the UK currency should be seen as the first of three distinct stages in the effects of Brexit on the Irish economy. The graph below suggests that adverse currency movements tend to be reflected quickly and substantially in weaker Irish export performance. With exports to the UK of goods and services amounting to some 20% of Irish GDP (total exports amount to some 124% of Irish GDP), sterling weakness represents a material constraint on Irish export growth in both 2016 and 2017. More generally, the almost ‘domestic’ nature of the business and social ties between the UK and Ireland mean significant effects spill quickly across broad swathes of Irish business well beyond those sectors directly engaged in trade with the UK.
While the impact of weaker sterling on the Irish economy is reasonably straightforward, the mechanics of the ‘second stage‘ of Brexit that encompasses negotiation of the UK exit process and the terms of the post-exit relationship with the EU are notably less so. Uncertainty about the precise terms of ‘Brexit’ could continue for a number of years, implying (i) a correspondingly prolonged period of uncertainty about the precise economic consequences and (ii), as the status quo would continue to operate for some significant time, no immediate changes of a technical nature would impinge on Irish business.
The ’third stage’ of Brexit relates to the period of the post-exit relationship between the UK and the EU. While various models such as those implied by the EU’s relationship with Switzerland or Norway have been cited, there is no precedent that would provide a reliable blueprint for the UK’S future relationship with the EU. The precise nature of this relationship is almost impossible to predetermine at this point. The prioritisation of political considerations might lead to a radically changed and potentially much more unfavourable business environment while an emphasis on economic aspects would likely entail more limited regime changes.
In view of these many sources of uncertainty, it is not readily possible to suggest any detailed picture of the precise economic impact of Brexit on Ireland although it is generally agreed that the net effect will be negative and significant. A number of studies by the ESRI, Central Bank of Ireland and other agencies arrive at estimates broadly similar to that presented in our July credit note and suggest the impact of Brexit over time would be to lower Irish GDP by between 2% and 4% compared to a ‘no Brexit’ alternative. These estimates imply a large but not entirely catastrophic scale of impact. However, these calculations probably understate the nature and extent of disruption that volatile and uncertain business conditions might have on many sectors of the Irish economy.
The Brexit process may well be the most important external development influencing Irish economic conditions in the next year or two but it is far from being the only one. Fortunately, the Irish economy has improved dramatically over the past four or five years to the point where the prospect of Brexit raises serious concerns but does not automatically imply a catastrophe.
The normal convention to assess economic momentum in a country or region is to focus on the direction and pace of changes in GDP. For a variety of reasons but primarily the relocation/reclassification of a substantial element of one multinational’s activity to its Irish operations, GDP data for 2015 bore no resemblance to the conditions experienced by most Irish businesses or households. The graph below highlights the extraordinary divergence in 2015 between measured GDP and jobs growth-an important barometer of economic conditions.
In the absence of an alternative summary measure of Irish economic activity that is understandable and acceptable internationally as well as demonstrably superior to GDP over a sustained period, we examine the main components of GDP separately as well as other indicators such as jobs growth and house prices to assess the current temperature of the Irish economy.
On an annual basis, the pace of consumer spending growth has eased through the quarters of 2016, a softening which is at odds with the improvement in labour market data but entirely consistent with the evidence from relevant tax headings and the more cautious tone of consumer sentiment readings of late. This has prompted us to revise down our forecast for consumer spending growth for the year as a whole from 3.5% to a still solid 3%. With jobs growth healthy, earnings picking up slightly and fiscal changes modestly boosting household spending power, we see a similar pace of increase in consumer spending prevailing in 2017 to that in 2016.
Our forecast for investment for 2016 reflects strong increases in building and construction. The third quarter saw the continuation of rapid increases in building evidenced in a 19% Y/Y gain which was led by a 26.8% Y/Y increase in construction of dwellings. With investment in construction now accounting for some 5.5% of Irish GDP compared to an EU average share of close to 10% of GDP, the likelihood is that outsized growth in construction will remain a significant impetus to Irish economic growth for some years to come.
Another important feature of recent Irish investment data has been a very volatile pattern in investment in intangibles caused by the lumpy nature of purchases of intellectual property patents. The latter are related to company specific developments rather than broader conditions in the Irish economy. As such transactions usually involve international transactions, the effect on investment is offset by an effect on imports and, consequently, such activities tend to be neutral in their impact on Irish GDP.
The major driver of outsized Irish GDP growth in 2015 was an exceptional gap between export growth of 34.4% and import growth of 21.7%. As mentioned previously, this largely reflected the relocation and reclassification of the activities of one multinational. For 2016, we see relatively modest growth reflecting in part the shadow of the 2015 outturn. We see a somewhat faster expansion in exports in 2017 notwithstanding some adverse impact from sterling weakness as this should be countered by stronger increases to other destinations
Given the overall composition of Irish trade, the aggregate headline performance of exports in coming quarters may be more heavily influenced by the performance of the latest generation of products from Irish based multinationals as they are by Brexit-related issues. However, as such exports entail significant imports, the net trade performance may make a more modest contribution to economic growth overall.
Taken together, these elements suggest that activity remains on a positive path and appear consistent with a solid GDP growth rate of around 4% in 2016. There are also signs of a more cautious consumer, a continuing catch-up in construction and tentative signs of some impact from sterling weakness on goods exports. We also envisage some dampening influence from Brexit related uncertainty on companies’ capital spending plans. Partly offsetting these influences are a continuing catch-up in construction, a modestly more supportive fiscal stance and a pick-up in household spending power. On this basis, we expect that that growth will moderate further towards a 3% pace in 2017.
The GDP growth rates we envisage for this year and next are reasonably healthy but far from white hot. Reflecting spare capacity and intense competition, the trend in Irish wages and consumer prices has remained consistently soft even relative to subdued international trends and we see slightly negative inflation this year giving way to a very limited rise in consumer prices of about 0.5% in 2017.
Much clearer signs of a strengthening Irish economic upswing in recent years are to be found in a lengthy sequence of robust jobs data. The most recent data for the 3rd quarter of 2016 show an annual increase for the fifteenth successive quarter that in turn has prompted a substantial fall in unemployment as the graph indicates. The monthly unemployment rate for November is now estimated at 7.3%. So, unemployment is now comfortably less than half of the January 2012 peak of 15.2% and notably less distant from the low-point of just under 4% seen a decade earlier.
The pace of jobs growth continues to be notably faster in Ireland than elsewhere. Numbers at work in the Irish economy were 57.5k higher in the 3rd quarter of 2016 than a year earlier. This 2.9% pace of increase compares with increases of 1.7% in the US and 1.4% in the UK over the same time period. The latest available data for the Euro area show jobs growth of 1.2% in the year to the third quarter of 2016.
It is likely that jobs growth will ease somewhat in coming quarters as the impact of weaker sterling and more broadly based uncertainty about global economic developments prompt a more cautious approach to new hiring. However, the spread of job gains seen in recent data hints at a capacity to weather potentially more difficult economic conditions in the coming year.
Stronger than expected labour market indicators of late data have prompted us to raise our forecast marginally for employment growth for the full year of 2016 from 2.7% to 2.8% while we have also reduced our forecast of the average unemployment rate fractionally to 8.0%. We continue to see jobs growth in the region of 2% for 2017. An emerging recovery in the workforce is being boosted by the return to net inward migration (potentially picking up once the UK invokes Article 50 to leave the EU) and some increase in participation rates, job gains of this magnitude could result in an average unemployment rate next year falling close to 7%.
The behaviour of Irish house prices continues to be a closely watched barometer of conditions in the broader Irish economy and a pointer to the health of the public finances and the domestic financial sector. This signalling capacity is diminished to the extent that house price movements also reflect ongoing difficulties in rightsizing the supply of dwellings to substantial fluctuations in housing demand. House price data for the third quarter of 2016 have shown a pick-up in the annual rate of residential property price inflation, the fastest pace nationwide (+6.9%) since the second quarter of 2015.
One important element influencing prices at present is the re-emergence of pent-up demand as the dearth of ‘normal’ purchasing activity through the past six or seven years translates into a bulge in buying intentions. A strong jobs market, renewed net inward migration and the continuing buoyancy of rents are offering increasing support to purchasing demand at present. As the graph illustrates, the gap between new mortgage drawdowns, a barometer of incremental demand and new completions, and a measure of additional supply, has been increasing of late in a manner that would underpin growth in property prices. This imbalance also acts as a significant constraint on the pace of new lending growth and, consequently, on the expansion of the balance sheet of the Irish financial sector. Notwithstanding a number of initiatives, the shortfall in supply is likely to diminish relatively slowly over coming years.
The recent trend in Irish property prices might also reflect the manner in which the market is adapting to a couple of important policy interventions. One possibility is that that the market might now have significantly adjusted to the ‘shock’ of the initial introduction of CBI lending limits which contributed to the sharp deceleration in property price inflation seen through the second half of 2015. The slight loosening of the CBI constraints announced in November 2016 should further underpin residential property prices in the year ahead. It could also be that some anticipation of the likely impact of Government measures to assist homebuyers first mooted in May. It seems likely that the formal announcement in Budget 2017 of a tax rebate of up to €20k for first-time buyers of new homes will provide some further support to house prices in coming months.
A final and important consideration in terms of the outlook for Irish housing prices is the extent to which current valuations are aligned with ‘fundamentals of the Irish economy’. There is no perfect metric in this regard but some perspective is provided in a report released by the European Systemic Risk Board in late November. It suggests that on a range of traditional metrics, Irish house prices may still be somewhat undervalued
Policy focus is shifting slightly
Another notable positive for the Irish economy which should support activity in coming years is a marked turnaround in Ireland’s public finances achieved after a prolonged and painful adjustment. The latest IMF projections suggest that only three EU countries will have a smaller deficit as a percentage of GDP in 2017 than Budget 2017 data envisage for Ireland. The graph below highlights how remarkable the improvement in Ireland’s fiscal position has been and draws on our economic forecasts to set out prospective developments in coming years.
While concerns about public deficits and debt will remain a key influence, they are no longer seen as the sole focus of Irish economic policy. Although Budget 2017 keeps Ireland’s public finances on an improving trajectory, it also marks a subtle shift in emphasising a requirement to provide some modest support to activity and incomes in an Irish economy that is still recovering and faces several headwinds in the year ahead.
This slight shift has drawn criticism-albeit fairly restrained-from some quarters. A joint statement from the EU Commission and European Central Bank in early December noted ‘Ireland's fiscal adjustment has been remarkable but slowed in 2016. While broadly compliant, the Draft Budgetary Plan implies a risk of some deviation from the required adjustment towards the medium-term objective in both 2016 and 2017.’ The structural balance is expected to improve from 2.2% of GDP in 2015 to 1.9% of GDP in 2016, a clearly smaller drop than the 0.6% of GDP envisaged in Ireland’s Medium Term Objective under EU fiscal rules. Similarly, Budget forecasts for next year imply a €200mn overrun in public spending (the equivalent of 0.07% of GDP) relative to the Expenditure Benchmark for 2017.
These deviations are relatively modest and a strongly positive trend in Ireland’s public finances remains in place. For example, the improvement envisaged in the structural balance- from 1.9% of GDP this year to 1.1% of GDP in 2017 is notably larger than required. It is true that a likely windfall increase in Corporation tax revenues has contributed to a step-up in public spending but recent exchequer data suggest the persistence of strong growth in corporation tax revenues. Moreover, the rather arbitrary nature of the EU fiscal rules tends to incentivise behaviour of this sort.
To emphasise the continuing importance of fiscal restraint, it should also be noted that Budget 2017 committed to establishing a ‘rainy day’ fund beginning in 2019 and set out a new target for the debt to GDP ratio of 45% for the middle of the next decade. This new target is below the EU standard by roughly the amount that the upward level shift of GDP IN 2015 reduced the debt to GDP ratio at that point, signalling a determination to sustain a meaningful improvement in Ireland’s debt metrics.
More fundamentally, as the subtly different tone of the IMF’s early December comment acknowledges, ‘ Given Ireland’s strong track record of fiscal discipline, the moderate fiscal adjustment planned in 2017 strikes a reasonable balance between advancing deficit reduction and addressing public expectations for a growth dividend.’ In this context, Budget 2017 has to be seen in the context of a world that is currently struggling to get to grips with a range of political and economic uncertainties and a fair measure of political instability. In particular the rise of populism and a backlash against the austerity of recent years makes for an altogether more testing political backdrop to policymaking. In these circumstances, the achievement by a minority Government made up of one political party and a loose alliance of independents in constructing a reasonably coherent budget package is unlikely to be lost on financial markets or international investors.
The relatively modest measures announced in Budget 2017 amount to just under a half a percent of 2017 GDP. The envisaged scale of adjustments to public spending and income taxes goes only a little further than ‘indexing’ these aggregates to expected increases in relevant prices and wages thereby preventing a deterioration in the real level of public services or an increased effective rate of taxation for workers getting even modest pay increases.
The harsh and recent lessons of the consequences of unsustainable public finances will be an important constraint on Irish fiscal policy in coming years but in Ireland, as elsewhere, political and economic arguments for a somewhat more supportive Budget stance are likely to increase. Tensions in this regard may be a noisy feature of discussions about fiscal policy settings worldwide in coming years.
A key positive for the Irish economy in terms of fiscal sustainability and broader economic health is the prospect that the comparatively strong growth performance seen through most of the past forty years can continue into the medium term. Recent estimates produced by the Economic and Social Research Institute suggest a potential growth rate of 3.7% per annum for the period to 2020, a figure that is broadly consistent with KBC Bank Ireland estimates. While Brexit and the possibility of more protectionist policies in the US pose significant downside risks to the realisation of this potential, the strong recovery from the recent crisis argues undue pessimism in this regard.
An important consideration in terms of the longer term outlook for the Irish economy continues to be an exceptionally positive demographic profile, with a young and comparatively well-educated workforce being augmented by the fastest ‘natural’ population increase in the EU. As net migration has again turned positive, population growth in a 1-1.5% range is envisaged in coming years. In turn, strong productivity growth (if somewhat flattered by the influence of the multinational sector) suggests that the performance that saw Ireland ranked as fastest growing EU country in each of the years 2014 to 2016 is unlikely to materially diminish into the medium term.
This non-exhaustive information is based on short-term forecasts for expected developments in the economy and financial markets. KBC Bank cannot guarantee that these forecasts will materialize and cannot be held liable in any way for direct or consequential loss arising from any use of this document or its content. The document is not intended as personalised investment advice and does not constitute a recommendation to buy, sell or hold investments described herein. Although information has been obtained from and is based upon sources KBC believes to be reliable, KBC does not guarantee the accuracy of this information, which may be incomplete or condensed. All opinions and estimates constitute a judgment as of the date of the report and are subject to change without notice.