Entre l’ideal et le faisable
Germany may well already be in recession
German Industrial production (IP) fell again in July. If IP stabilises over the rest of the summer, over the third quarter (Q3) the quarterly decline would reach 1.6%, only marginally less bad than in Q2 (-1.9%). This makes the Bundesbank’s warning of a mid-year technical recession even more credible (GDP fell already in Q2). This confirmed the earlier – and just as bleak – message from the factory orders earlier in the week. A lot of the comments emerging right after the release focused on the fact that the biggest negative contribution came from foreign clients outside the Euro area. This is intuitive: in a configuration of trade war between the US and China, one would expect demand weakness to come from non-European clients.
However, factory orders are a very noisy variable. If one smoothes the data over three months, it is impossible to see any major difference between the two sources of foreign demand (Exhibit 1). There is actually only one episode over the last 15 years when a significant wedge appeared between the two components of Germany’s foreign demand: the relapse in recession of the periphery in 2012-2013. Most of the time, the two cycles are synchronised, as the comparison of German exports to the two areas also suggests (Exhibit 2).
This is another illustration of the degree of international integration of the manufacturing industry. Given the growing involvement of the various national producers within global output chains, shocks tend to materialise across all constituencies very quickly. Although Europe is a recipient, rather than a generator, of the ongoing global downturn, the European markets are not providing German producers with much offsetting support.
This gets us to a very simple point: the current predicament of the German economy is not specifically a product of their exposure to China, or to the global investment cycle (capital goods and cars account for 40% of their total exports) but quite simply to their reliance on exports and manufacturing in general. As long as global trade is impaired, the German economy will struggle.
In terms of policy response, two options are open. The first one would be to try to offset the weakness in the volume of foreign demand by improving the competitiveness of German exports – to the detriment of wages and thus domestic demand. The second would be to “write off” for the time being the external engine of the German economy and spur domestic demand with a fiscal push. We suspect that 15 years ago the first option would have been chosen without hesitation. Times have changed though. We note that this week the leading union IG Metall demanded a wage rise of 8.5% for temporary workers. There is no sign of the consensual “wage moderation” motto of the end 1990s/early 2000s.
Today, at least in academic circles, the debate has started on the appropriateness of a fiscal stimulus. Our impression though is that the dominant views in Berlin are either that it is only a soft patch and there is no reason to react too quickly, or – with the same end result, i.e. an absence of decision – powder has to be kept dry for when the downturn will be more evident. In the absence of mass unemployment, recessions – as long as they are not protracted – are probably more socially acceptable.
No ideal solution
The additional weakness evident in the European dataflow relative to the ECB’s July meeting would normally pave the way for a “big package” announced on 12 September. We have remained more circumspect. In our 26 July Macrocast #8 “Monetary policy special”, we argued that “there is a fair chance the dollop of unconventional monetary policy the ECB could end up granting in September could be weak (i.e. “scrapping the barrel” on QE and pushing to, but not beyond, the current limits).” This was a minority view then, but a month is a long time in the world of monetary policy and it seems that the market is pricing less of a “bazooka” approach now, with yields rising back from the August lows.
We think a deciding factor in the market’s new pricing was Banque de France Governor Villeroy de Galhau’s interview last Tuesday. Until then, investors had appeared unfazed by the unease expressed by the habitual hawks on the need to re-start quantitative easing. After all, most of these hawks had opposed QE in 2014 and that did not stop the ECB. Conversely, that a “centrist” such as Villeroy de Galhau appears unconvinced by the need of another layer of bond buying is significant.
In our view, the ECB’s narrative lacks consistency at the moment. Most of the members of the Governing Council who have expressed themselves called for more fiscal stimulus. This was evident again in Bank of Spain Governor De Cos’ speech last weekend. We agree with that. But if even central bankers now consider that the fiscal leg of economic policy should take the lead, while they also recognize that additional monetary stimulus can come with adverse effects – to the point that another deposit rate cut must be “mitigated” – then the question of whether the monetary push is going to be a net positive arises. This was the crux of our argument last week in our discussion of negative rates (See Macrocast #11, 30 August 2019).
Still, the European Central Bank (ECB) needs to do “something” on Thursday, for two reasons. First, a “package” has been so heavily telegraphed over the last two months that their credibility would be at risk. Second, the deterioration in the data flow has been so obvious since June that the macroeconomic forecasts which are about to be released cannot but signal another drift in inflation relative to the ECB’s target. That the ECB’s tools are reaching the limits of their efficiency is one thing, but that the central bank would accept not to be seen as “at least trying” is another. A package is coming.
The basis of such package is likely to be another deposit rate cut. As often with the ECB efficiency and political acceptability criteria are mingled. In our view, even with tiering, a deposit rate cut is not going to spur the economy much, assuming it is even a net positive. But for the hawks it is a lesser evil than quantitative easing (QE) and its unsavoury proximity with deficit funding. So the deposit rate needs to fall. By 10 bps in our baseline, with some probability of a bigger decline to 20 bps (if QE is weak, the ECB may want to settle on a bigger move on conventional instruments).
Then comes “mitigation”. We have already expressed our doubts on the appropriateness of “tiering” but it is probably the natural slope right now. Buying bank bonds would make sense in our view, but the ECB’s preferred avenue to provide additional mitigation to banks may be an extra dollop of generosity on the incoming Targeted-Longer Term Refinancing Operation (TLTRO). Moving the dial on this instrument would also help create the impression of a “package”.
Bond buying is the thorniest issue. We do not completely exclude the possibility that QE is not resumed at all. It is now a tangible risk. But our baseline is still that the ECB will give us a “small QE”, i.e. a time-limited buying programme at a fairly low monthly pace , consistent with the current limits of QE, in clear, EUR25 to 30bn a month for 6 months, shared across corporate and sovereign bonds.
We do not think there is an ideal solution for the ECB is that respect. A proper “bazooka”, for which a number of sell-side firms are calling, would necessitate probably a bigger quantum but more fundamentally a potentially time-unlimited commitment to buying. This cannot be achieved in a convincing way without disposing of the 33% holding limit on bonds bearing collective action clauses , or dropping the capital key, and we think this is a difficult line to break. While it may not fall foul of the European Court of Justice per se, turning a national central bank into the deciding force in the potential restructuting of the debt of its own main shareholder (the government) is a big step to take.
The ECB may be left with an unappealing choice between not resuming purchases at all, while making it clear that such resumption is at the ready should the dataflow deteriorate further and keeping the potentiality of then exceeding the limits open – although we are not certain this would be necessarily very credible. Or re-start with a small quantum on a time-limited basis, at the risk of making it clear to the market that the limits are indeed very difficult to re-visit. We keep this second option as a baseline essentially because not buying at all could trigger a bigger “hiccup” in the sovereign and credit market.
Down the line, beyond such transitory “hiccup”, the issue is whether a “disappointment” next Thursday would trigger a significant and lasting tightening in financial conditions. We do not think so. The market losing its “toy bazooka” could throw a tantrum, but if the market understands the ECB’s decisions as acknowledging that monetary policy’s capacity to address the current downturn is now very limited, in principle it should look beyond a smaller than expected quantum of bond purchases and focus on an even more protracted period of sub-par inflation and growth. Coupled with a further decline in the short end of the curve and strengthened forward guidance, this would normally keep yields on the risk free asset in check, especially in the absence of a decisive turnaround in fiscal policy and thus the expectation of a higher supply of paper, or a proper reversal of the newsflow on the global macroeonomic risks. True, as often Italian bonds would have been key beneficiaries of a big ECB bond buying programme, but at least in the short run such disappointment should be offset by the arrival of a more euro-friendly administration in Rome (see Menut, A. and Tentori, A., “italy; New cards on an old table”, AXA IM Research, 5 September 2019).
Of course Mario Draghi can still get his preferred option of a bigger package. The tactical advantage of doing so is obvious: it would be better for the ECB to make all the controversial decisions now so that Lagarde does not need to spend any political capital on her arrival. And Draghi is a formidable tactician with plenty of intellectual authority at his disposal. Still, judging by the noises from Frankfurt, it seems the bazooka is definitely shrinking.
Brexit: Powerless Prime Minister (another one)
If a month is a long time in the world of monetary policy, a week can feel like a lifetime in politics, especially in Brexit politics. Last week our contention was that if the Prime Minister was faced with a parliamentary majority forcing him to request an extension, he would precipitate elections. Elections are still very likeling coming, but the opposition wants first to be absolutely sure “no deal” by default on 31 October is completely off the table to give Johsnon the votes he needs to trigger such elections. Such is the level of trust in British politics at the moment.
The market still treats the absence of bad news as good news. That we are more likely to get another reprieve until early 2020 was saluted by a nice rebound in Sterling. The idea probably is that any delay at least preserves all possible outcomes. The issue for us is that while the worst outcome (exiting without a deal) is for now on the back-burner, it is still very hard to see what the final outcome could be.
Assuming the de facto alliance of the opposition parties with some elements of the tory party would outnumber tbe conservatives and the Brexit Party in the next parliament, with elections happening in the weeks after an extension is granted, they would still need to settle on a solution. They are actually quite divided and organising a second referendum would then be needed. This would re-create the possibility of a another binary outcome, which the market may well find difficult to trade.
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