Autopilot down, back to manual

Autopilot down, back to manual

  • The news-flow has turned more challenging, between the coronavirus crisis in China and concerning noises from the US administration on the trade relationship with the EU.
  • The ECB must strike a delicate balance between “forward guidance” and a “no autopilot mode”. While this is not for immediate consumption, the ECB could inadvertently trigger market pricing of some “technical rate hike” which may push the euro up.
  • The monetary stimulus is not going where it should. The Euro area’s resilience in 2019 came from the household sector, with decent consumption and residential investment. Corporate capex remains stubbornly weak and is not responding to the extraordinarily low level of interest rates. The risk is that the region stays stuck in low investment/low productivity gain regime.
  • UK: to cut or not to cut. The Bank of England looked set to cut rates next week, but some better data may stand in the way.  On balance we stick to our view (that they will cut),  assuming the Monetary Policy Committee will look beyond what might be a short-lived “Boris bounce”.

Abrupt end to the expected easy ride

Most economists were probably expecting a fairly easy ride at the beginning of 2020 – your humble servant most certainly did. The bulls were counting on the good news on the US-China trade war to gradually percolate through the global cycle to bring us to a more robust growth rate. The bears were warning against undue euphoria and focusing on the long-term headwinds (we made the case here quite often). But by and large that markets would enjoy some peace and quiet in the first half of 2020 was very consensual, allowing economic policy to be “on autopilot”. Alas, unforeseen exogenous events are standing in the way, generating a high level of uncertainty.

Escalation in the Middle East was absorbed swiftly (for now), but the global economy now needs to deal with another epidemic originating from China. It is far too early to risk any quantification of the economic impact of the current coronavirus crisis, but faced with non-linear shocks such as this one, the reasonable first approach is to look for precedents. A 2004 paper which we found quite thorough in its methodology suggests the 2003 SARS crisis lowered GDP by 1.1% for China (very close to the assessment of the current crisis S&P disclosed last Thursday) and 2.5% in Hong Kong, but by only 0.1% for the US. Note however that since 2003 the weight of China in the world economy has risen significantly, so the spill-over would probably be bigger. But again, at this stage it is impossible to know if this is the right precedent. Contacts between China and the rest of the world have soared in 15 years and the emergence of large scale “autonomous” contagion points outside Greater China would obviously change the equation.

One of the macro consequences we can already draw from the crisis at this stage is that reading cyclical data from China may become very difficult in the coming months. Indeed, if the data flow relapses after its encouraging rebound of the last two months – e.g. if the PMIs dip again – it will be next to impossible to disentangle what is a knee-jerk and probably transitory reaction to the measures taken to contain the epidemic or if the economy is heading south again for more fundamental reasons. Early year data is always difficult to assess in China because of the varying holiday seasonality. It is likely to be even worse this year. We can’t insist enough on the centrality of the China scenario for the global 2020 macro outlook: whether some rebound can be expected thanks to the fading trade war or if the need to address the domestic imbalanced coupled with the structural headwinds will cap domestic activity is likely to set the tone for global manufacturing cycle. We may have to wait longer to get any hint.

At the same time, it seems we have to ascribe a higher probability to the risk that the US administration, after “defeating” China on trade, chooses to pivot to the European Union. The message delivered in Davos to the Europeans by US government officials was not very subtle: they haven’t given up on using the threat of tariffs to get concessions from their closest allies, and this in spite of France’s decision to postpone the actual payment of the digital tax, seen in Washington DC as aimed squarely at US tech companies. We thought this issue would re-surface at some point in 2020 – especially once the presidential campaign starts in earnest – but we would not have expected so blunt messages so early in the year. We will make our usual point on “trade war” here : the biggest impact does not come from the actual tariff hikes, at least not immediately. Uncertainty is the key transmission channel, and investment the main victim.

Of course, just like what happened with the trade war with China, at some point market pain in the US would probably prompt the White House to compromise, but it may take time. So right now, we are dealing with the combination of less visibility of the Chinese outlook and more uncertainty on the European one. Markets are wrongfooted and they may shift from “blue sky” optimism to a more cautious attitude.

On the European domestic front, we will need to keep an eye on Italy. Luigi di Maio has resigned from his role as leader of 5Star, which in itself is generating some uncertainty. However, at the time we are finishing this Macrocast the first exit polls suggested that centre-left Democratic Party (PD) has managed to stay in power in its historical stronghold of Emilia.  This may provide the coalition with a welcome respite. In any case, given the message from national polls it would not make sense for 5Star and PD to create a situation which would make new general elections necessary. The baseline thus remains that the coalition continues, but even outside government Lega leader Salvini has some substantial capacity of influence policy-making. By highlighting the concessions Italy would have to accept to unlock the reform of the European Stability Mechanism and banking union project, he has turned what was a technocratic issue into a domestic political problem, forcing the government into blocking the European proposals. This was part of our “top 5” concerns for 2020 we highlighted in our “back to school” Macrocast two weeks ago: that progress on European issues is stopped because of internal political difficulties.

ECB: delicate balance between forward guidance and autopilot

Given the latest noises from Davos it is unfortunate the European Central Bank (ECB) chose to justify its slightly rosier macroeconomic assessment, as conveyed by Christine Lagarde last Thursday, by lower risks on trade. It seems the central bank had decided to move to a “glass half full” mood. We did not learn much from the press conference, but we think there is a good case for the market to price some moderately hawkish rhetorics from the ECB in the coming months.

The changes may look microscopic at first glance, and we may focus too much on the change in wording on inflation from detecting “some indications of a mild increase in underlying inflation” in December to “some signs of a moderate increase” last week, but we think it is possible the ECB falls into some “confirmation bias”. Indeed, it is obvious a growing number of Governing Council members are uncomfortable with the current monetary policy stance. Given the lack of new weapons and the possibility that some of the current ones are now generating adverse effects (in particular the negative deposit rate) there may be an understandable “impatience” to see progress on the inflation target.

In an interview with  Bloomberg the day after her press conference Christine Lagarde chose to detach current monetary policy-making from the strategy review, denying the central bank was in “auto-pilot mode”. This is fair – there is no reason the central should refrain from making decisions if need be before the completion of its review - but the central bank must be cautious not to undermine its forward guidance (FG). FG is always conditional – a central bank must retain its capacity to react to shocks – but its very success hinges on providing the market with some visibility. The bar to actual changes should be high.  

The market’s distribution of probability on the deposit rate has already changed a lot since the ECB’s latest move in September 2019. The central banks has been communicating on policy rates remaining unchanged or lower, but market pricing has been increasingly discarding the possibility of further cuts (c.5% probability on Friday, against nearly 40% in mid-December (see Exhibit 1). This may merely reflect the improvement of the balance of risk…or it could be influenced by a belief that irrespective of the macroeconomic situation there is no longer any appetite for further rate cuts at the Governing Council, following for instance Banque de France’s Villeroy de Galhau’s point that we should talk of “low for longer” instead of “lower for longer” to characterise the current policy stance.

Exhibit 1 – Market thinks the depo rate has met its floor


We are not big fans of negative rates ourselves, so say the least. We think it came as a very sub-optimal compromise solution when the ECB could not agree on quantitative easing and has become an impediment to the ECB’s capacity to provide stimulus given its “political toxicity”. But equally we recognise that it can have strong non-linear effects on the exchange rate. This is not for immediate consumption, but we are concerned of the impact it could have on the Euro area’s competitiveness if the distribution of probability starts moving to the right in Exhibit 1. Christine Lagarde has rightly downplayed the significance of the return to zero of the Riksbank’s policy rate for the ECB, but gradually in 2020 we think voices in the Council will be raised to call for a “technical hike”.

The monetary stimulus is not going where it should

In the minutes of the previous Governing Council meeting the ECB expressed it was “vigilant” on the efficiency of its instruments. Beyond the net merits of various instruments and by how much GDP is boosted by the monetary stance, we think the debate should focus more and more on the quality of GDP growth, since this will have a lasting impact on potential growth.

The credit impulse – the year-on-year change in the flows of loans as a ratio to GDP – remains positive for households, while it has dropped significantly for corporations (see Exhibit 2). The latter tends to be more volatile than the former, and we will watch with interest the new batch of data coming out this week, but for now the massive decline in borrowing rates is triggering a much more positive response from households than from the corporate sector.

The resilience in job creation is obviously another factor. Feeling less concerned with the possibility of losing their jobs, individuals are readier to take advantage of low interest rates to leverage themselves. However, we also note (see Exhibit 3) that the growth rate of real labour income (the change in real wages combined with the growth in employment), although still quite decent, has started to slow down. Wage behaviour remains the problem. Normally given the current state of the labour market – surveys suggests labour shortages are still above their long term average – we should have already seen real wages picking up. There is enough job creation and credit to support consumption and residential investment, but the weakness of real wages is the symptom of something more fundamental.

There are wide discussions on the reasons behind this “wage deficit”. On element may be “acquired wage moderation”, a change in labour market institutions and behaviours weighing on wage growth as a legacy of the mass unemployment past. We were intrigued for instance by the statement from IG Metall leader Joerg Hofmann on Friday that he “would not put out a quantified demand on wages” this time, to focus instead on preserving jobs. But beyond those changes, the weakness of productivity gains – also visible in Exhibit 2 – puts a hard cap on wages.

Exhibit 2 – Loans go to households, not businesses                   


Exhibit 3 – Lots of job, not a lot of pay

Some of this weakness in productivity is “exogenous” – possibly stemming from a slowdown in technical innovation, as per Gordon’s view – but we are concerned with the developed world (we find similar features in the US) settling in an endogenous low investment/low productivity trajectory. Indeed, investment does not merely spur potential growth by adding production capacity. It also crystallises innovation by renewing capacities. Corporate investment is still lagging pre-Great Recession levels, especially in Germany (see Exhibit 4). We have already discussed in Macrocast the possibility that, beyond the rise in uncertainty and the legacy of the Great Recession this reflects a decline in corporate profitability. We would have the ingredients for a vicious circle here: low investment keeps a lid on productivity growth, which itself caps real wages and profitability, in turn weighing on the investment outlook.

This is why we think a public investment push is the right policy approach today. It is not just about triggering some short term cyclical boost to offset a lack of external demand. It is also about making sure domestic capacities, in particular infrastructures, are still up to date, thus supporting productivity. In Germany, correcting for the consumption of fixed capital (i.e capital obsolescence) the stock of public capital has been stagnating for the last two decades. This has unfortunately spread to the entirety of the Euro area after the sovereign crisis of 2012 (see Exhibit 5). A coordinated push is necessary.

Exhibit 4 – Weak corporate investment                                                 


Exhibit 5 – Gross public investment barely offsets public capital obsolescence


UK: to cut or not to cut

Before the Bank of England’s Monetary Policy Committee went in purdah, we had a flurry of comments from five members strongly hinting at a pre-emptive rate cut this week. Since then however the UK dataflow has been quite strong – with in particular the highest services PMI in 14 months and still good labour market data. The FX market has taken notice. This makes the bank of England’s job quite thorny, obviously. It is likely that they had already come to a conclusion before the data was released, and central banks are normally not swayed by one data batch. In any case, the UK may be in the middle of a “post elections” bounce which may not resist the hard realities of negotiating a difficult free trade agreement with the EU. It would make sense to be pre-emptive.

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