Question de point de vue
- The steep upward revision in Covid-19 figures last week makes a lot of recent projections obsolete and raises uncertainty. Quick V-shape recovery scenarios – until recently favoured by sell-side research – are optimistic in our view.
- The European Central Bank doves have finally awakened. They get a new ally in Isabel Schnabel, at least to protect the status quo. Market movements have produced a spontaneous monetary easing, but the harsh reality though is that the arsenal is empty.
- We look again into the “inflation perceptions” debate. We find no evidence of a growing gap between measured and perceived inflation in France and Germany, nor that housing costs are a specific source of divergence.
- Sajid Javid’s resignation as Chancellor of the Exchequer should be taken seriously. The British government “means business” as the free trade agreement negotiations are looming. We don’t think any “climbing down” from fierce rhetorics can come without a significant cost for the British economy and/or asset prices.
Homework to re-do from scratch
Last week Beijing moved from counting only those for whom the test detected the genetic signature of the virus to those whose clinical signs are consistent with Covid-19 infection. Unsurprisingly the financial markets did not react well to the ensuing 15k jump in the number of cases between the 12 and the 13 February. But beyond the impact of the sheer number, the “break” in the data is going to make a lot of the current projections for the progress of the disease obsolete.
We suspect the market will be closely following any emerging projections taking into account the new data, then comparing those forecasts to the incoming numbers in search of indications propagation is definitely kept in check, but the magnitude of the revision is likely to make observers more prudent. Hubei province – where the epidemic started – has accounted for the brunt of the statistical break (14,840 out of the total 15,150 cases attributable to the methodological change) which arithmetically means that the “spreading ratio”, i.e. the share of the rest of China in the total number of cases is lower (20% instead of 26%). Still, beyond the fact that it is not obvious the counting process is exactly the same across the territory, it would be too early to conclude that the containment measures are effective. Indeed, in Hubei the recent releases have been somewhat reassuring (1,843 new cases “only” were recorded there on February 15, down from 2,420 the day before) but in the rest of China the number of cases increased by 307 on February 15 after a “near pause” at +40 the day before. In addition, we find in a lot of sell-side research an implicit identity between passing the peak of the epidemic and a swift resumption of economic activity in China. This may not be the case. Passing the peak will mean that the containment measures have been efficient, but removing them too quickly could re-start propagation. There will be a lag. Readers interested in our more substantial take on the economic ramifications of the epidemic can take a look at our note here.
The Chinese authorities are taking measures to mitigate any impact of the covid-19 crisis on financial stability. The central bank started last week to issue targeted loans totalling CNY300bn (“special re-lending funds”) directed at supporting lending to companies in 10 areas severely hit by the virus. While the government is urging businesses not to suspend payments – in particular to employees – cash flow positions are probably quite stretched by now. However the PBOC facility needs to be intermediated by banks (the nine major national banks together with some local credit institutions) and their own activity may also be disrupted in those areas.
We still have to rely on indirect measures of economic activity in China for now to gauge the damage. According to Morgan Stanley in the middle of last week national passenger traffic was down 85% relative to last year, while coal consumption was down 43% at 6 large power generation groups. In the absence of hard data from China we are left with monitoring closely what comes from the rest of the world. Taiwanese exports already fell by as whopping 7.6% yoy in January, the brunt of the decline coming from shipments to the whole of Eastern Asia. At the end of next week we will take a hard look at the preliminary data for the first 20 days of February for South Korean exports given their sensitivity to the Chinese cycle.
In the developed world, the dataflow for 1Q remains scarce. It is fair to say though that the start of the year has not been stellar in the US for now. Manufacturing output fell by 0.1% mom in January, after a downward revised +0.1% in December. Unsurprisingly, the trouble at Boeing is showing up, with a 10.7% decline in “aircraft and parts” production. The rest of the industry was not particularly strong though. This week’s Empire manufacturing index for February may shed more light this sector.
Still, no one was counting on industrial tailwinds in the US in early 2020. The behaviour of US consumers matters more. US retail sales have been disappointing for January, with the key “control group” component stagnating. This is a fairly volatile series and given the strength of the labour market there is probably little reason to be concerned at this stage. And the same day the Michigan consumer confidence came out strong. Still, we probably need to brace ourselves for one of those “soft start of the year” which have become quite frequent in the US, irrespective of the impact of the epidemic.
Finally, focusing on the covid-19 epidemic should not make us forget other macro developments in the world economy. On Friday the US administration upped the ante in the dispute with the EU on Airbus, raising the import duty on aircrafts imported from the EU from 10% to 15%. Those who like their glass half full will note that at least the White House did not extend the additional duties on other products (except quite oddly for “butcher’s knives from France and Germany”). Still the US trade authorities have made it plain that they reserve the right to push further in the absence of concessions from the EU (for instance dropping their own case against Boeing). It is not full-on “trade war” but skirmishes continue to abound. This will put the EU in a complex position given the misalignment of some national interests when it comes to trade policy.
Dovish force awakening
Jay Powell in his testimony to Congress last week acknowledged the downside risk to growth posed by the covid-19 epidemic, stating that “there will be some effects on the United States” but “resisting the temptation to speculate”. The Fed will focus on any “persistent” and “material” impact on the economy, which suggests the bar is fairly high for any action, but at least there is some monetary policy space left there. It is more complicated for the ECB.
Arguably, for now the “automatic stabilisation” mechanism of the central bank’s data-dependent forward guidance is working, in the sense that the market has started tentatively to price a further depo rate cut by year end. This was helped by some anonymous ECB sources quoted by Market News mentioning that the probability of another cut had “risen”. Such minor shift may have contributed to the depreciation in the euro exchange rate which, combined with the relapse in long term yields, is producing a spontaneous easing in financial conditions. Still, the bilateral decline vis-à-vis the dollar since the beginning of the year (-3.1%) has been steeper than in trade-weighted terms, which suggests that we are dealing now with something which may be more some generic “safe haven” flow towards the US currency than an idiosyncratic weakness in the euro.
Yet, there is a change in tone from the ECB. Philip Lane was unusually straight-forward in discussing the “reversal rate” – i.e. the level beyond which the negative deposit rates becomes a net headwind, stating that the Euro area is “clearly not at that point”. This comes after several months of focus – in the ECB communication – on the adverse effects of the accommodative policy. Isabel Schnabel – the new member of the the ECB board – gave a wide-ranging speech, combined with a long interview in Die Welt, debunking a number of popular myths on the impact of the ECB policy on the German economy. This “defence and illustration” of the central bank in the German media is welcome, given the Bundesbank’s reluctance, to say the list, to engage public opinion on these issues. Still, our impression is while Isabel Schnabel is defending the status quo – i.e. the current monetary policy stance – the bar would still be quite high for her to support additional easing. She publicly said last year that she would not have supported the September package had she been a member of the Council then.
Yet, we note that Christine Lagarde in her presentation to the European parliament of the ECB’s annual report chose not to elaborate on any additional step the central bank could take, instead focusing – again – on the fact that monetary policy cannot be alone in dealing with the headwinds blowing against the European economy.
Unfortunately, we are even more circumspect this week about the chances of a significant fiscal push this year in Germany. We had noticed at the end of January the request from SPD to bring forward the partial dismantlement of the “solidarity tax” due to take place at the beginning of 2021 to July of this year (see here – in German – for details). This was one of the first signals that the deterioration in external demand might trigger a re-think of budgetary policy there, even if the amount at stake (0.3% of GDP over one year) was small. But we suspect that the latest political crisis in Berlin (with Angela Merkel’s succession at CDU to start from scratch) is going to trigger a near-paralysis of decision-making in the months ahead.
Households are not hallucinating when it comes to inflation
Press reports suggest that the ECB may change the definition of its objective this summer already, instead of waiting until the end of the year with the scheduled completion of the strategy review. We interpret this as a signal that the central bank would be happy to generate some “rhetorical easing” to try to offset the lack of actual new policy options at this stage. Indeed, as we have already argued in Macrocast, we expect the central bank to shift to a properly symmetric inflation target, simply stating the ECB’s aim is to keep “inflation close to 2%” in the medium run, instead of the hawkish-tinged “below but close”.
This is however unlikely to deal with all the complexities of the debate. We have already discussed the temptation to change the measure of inflation from a “theoretical” point of view. This week we want to add some simple empirical points.
Changing the measure of inflation retained by the ECB is often presented as a manner to bridge a gap between inflation as it is perceived by economic agents and households in particular and its statistical measure. We start here by disputing not so much that such a gap exists – we don’t think the relevant data is yet available to assess this at the euro area level – but rather that any such gap has widened recently – for which we think we think we already have the relevant data.
In the US, surveys have been for a long time directly measuring what inflation rate households expect (for instance the University of Michigan survey). This has not been done in Europe until very recently. The Bundesbank has unveiled the results of a new pilot study implemented in three waves in the spring of 2019 which suggest the median household puts inflation in the coming 12 months at exactly 2.0% - which is probably good news for the ECB’s credibility. But we do not have such data for the Euro area as whole, and even for Germany alone we did not find in the Bundesbank report an assessment of where households actually believed inflation to be at the time of the survey (even if such question was included in the questionnaire for the third wave) which would be crucial to understand any discrepancy relative to the official measure.
However, the European Commission has for a very long time been surveying European households on their qualitative assessment of both past and expected inflation, i.e. whether they think consumer prices are accelerating or decelerating. In Exhibits 1 and 2 we looked a the relationship between the balance of opinion on past inflation and the actual year-on-year change in headline inflation measured by Eurostat, with a lag by one quarter. The correlation is actually quite good in both France in Germany. This single variable can explain around 50% of the variance of perceived inflation since 1997. We found – and only in the German case – only one cluster of “stubborn divergence”: in 2002 when the introduction of the euro notes and coins for a time disturbed the relationship.
We went one step further by looking at the stability over time of the relationship. For this we use a recursive analysis, returning the computed elasticity (i.e. by how much the balance of opinion on past consumer prices reacts to a change in the year-on-year Eurostat measure of consumer prices) each time we add one quarter to the sample. As shown in Exhibit 3 the coefficient has been remarkably stable (and very similar) in France and Germany over the last 10 years. In other words, even if it is not certain that households have the right perception of the absolute level of inflation, at least we can be reasonably sure that any such bias has remained constant for quite some time. There is not clear sign of a growing divorce between measured and perceived inflation in the two largest economies of the Euro area, which should be reassuring to the ECB.
Finally, given how heated the debate is on better taking into account house prices into the ECB’s preferred measure of inflation, we looked at whether house prices (here the price of purchasing houses) could help explain any transitory divergence between actual and perceived consumer prices growth. We calculated an “inflation perception gap” by subtracting from the actual balance of opinion on past consumer prices in the Commission’s survey the forecasted balance of opinion using the equations in Exhibits 2 and 3 (we also introduced a “dummy” variable to correct for the 2002 “ cluster”). When the green series is at zero in Exhibits 4 and 5 this means that inflation perceptions are exactly where they should be given where actual inflation was a quarter before (incidentally we are very close to zero in both countries at the moment…). We could not find any correlation between the growth in house prices and our “inflation perception gap”, at least not over the last 10 years (graphically there might have been something at play in the 10 years before the Great Recession).
In a nutshell, we don’t think there is any cause of alarm at this moment in time about any divergence between how the ECB has been looking at inflation and how it is experienced by households.
UK cabinet reshuffle: Boris Johnson means business
Sajid Javid’s resignation as Chancellor of the Exchequer was the big surprise in last week’s long awaited cabinet reshuffle by Boris Johnson. Beyond Mr Javid’s fate, an obvious observation after the change of personnel is that the Prime Minister has pruned all potential dissenters from his government. Boris Johnson was already commanding a large majority in parliament. He has firmed up his grip on the executive branch. If European negotiators were still counting on some capacity to foment divisions within the British camp, they will have to change their mind (we think they had already done so). The British “pack” is committed to the “maximum divergence” strategy which we think can only end up in frontal collision with Brussels. This was already obvious last week in Michel Barnier’s swift dismissal of the British initial negotiation position on financial services. There cannot be any permanent and unfettered access to the EU financial markets by UK-based firms without strong de jure regulatory alignment, which is precisely what the British government is rejecting.
But Sajid Javid’s specific case deserves some comment. He had been resisting in cabinet the most spendthrift ideas coming from the Prime Minister. His “last defence position” clearly was that if additional borrowing could be envisaged to fund extra investment spending, the golden rule (not funding current expenditure with debt) should remain a valid target. We have already argued in Macrocast that Boris Johnson’s economic strategy is potentially contradictory: he needs to provide enough fiscal spending to consolidate the newly conquered tory seats in the North, but he also needs to keep tax low to attract business in a post-Brexit Britain. There is obviously one valve of adjustment then and it’s the public deficit. We will have to wait until March to get the first proper fiscal bill of the new administration – and by the end of the weekend the press was reporting a potential delay beyond the current 11 March date for unveiling the budget bill - but we suspect it could be quite spendthrift. The market reaction has been swift: high spending means a stronger currency, as the Bank of England will be less inclined to cut rates further, and a stronger sterling is not good news for British equity.
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