Macrocast - The disappearing European risk-free asset

The disappearing European risk-free asset

Key points: 

  • Global dataflow: it’s not looking any better
  • Nowhere to hide: the curse of cyclical convergence
  • Policy inversion?
  • The disappearing European risk-free asset
  • Italy: never say never

It’s not looking any better

We see no big change in the overall configuration of global macro risks since our last Macrocast in early August. Uncertainty on the global trade war has not abated. Donald Trump’s decision to postpone the implementation of the 10% tariff hike on Chinese products to December reflects a willingness to avoid a price shock ahead of Christmas shopping rather than any real relaxation of the stance towards Beijing. The rhetorics have not improved, and China’s decision today to retaliate suggests resolution is not close. “No deal Brexit” is now explicitly seen as the most likely scenario by the French government, and any positive outcome on this issue – such as another extension or a proper “deal” – may well entail first an exacerbation of the political crisis in London.

Even the rare positive surprises should not be overstated. The market on Thursday briefly saluted the better-than-expected flash Purchasing Managers Index (PMI) reading for August in the Euro area, but the headline reading hid a concerning message from the sub-components outside France. In Germany, for the first time in five years, the number of firms expecting output to fall over the next 12 months exceeded those expecting an improvement. Also, the German PMI pointed to the slowest employment growth since 2014. It is a point we have already made in Macrocast: the labour market could well be the transmission channel from the deterioration in the external outlook to German domestic conditions. The Bundesbank’s warning about the possibility of a recession, with another negative reading for the third quarter (Q3) GDP after the Q2 contraction, is perfectly reasonable.

A consensus view at the beginning of the year was that the softening in the Chinese policy stance would start to materialize in domestic data by the summer, gradually offsetting the impact of the trade war. This is not happening. The cluster of data released on 14 August was quite disheartening, with both industrial production and retail sales coming markedly below expectations and decelerating in July. For these two indicators, the year-on-year (yoy) pace was worse than during the global contraction of 2009.

True, the US economy is still coming out broadly as an island of robustness. The Philly Fed and Empire indices were stronger than expected in August, and July retail sales rebounded nicely in July, but we don’t think it is enough to provide enough traction to the world economy, and in any case the most forward-looking indicators, such as factory orders, are concerning.


Nowhere to hide or the curse of cyclical convergence

The US looks all right but it is providing less support to export-dependent countries. In Exhibit 1, we look at two US cyclical indicators together with the yoy change in US imports. US imports are now flat, in line with what the manufacturing ISM suggests. This is a simple illustration that decent domestic demand, especially if it relies more on services-heavy consumption than investment, does not necessarily trigger a robust demand for products made in the rest of the world.

We look at this from a different angle in Exhibit 2. Final sales to domestic agents (the sum of private and public fixed investment and consumption) measure domestic demand irrespective of whether it is met by domestic production, imports or de-stocking. Between the early 1990s – the boom in the opening of the US economy with North America Free Trade Agreement – and the Great Recession of 2008/20009, a 1% change in final sales would be consistent with an increase in imports of 2.5%. Since 2011, this elasticity has fallen to 1.3. The US engine may well be humming nicely, but its capacity to pull the world economy is lower.


Exhibit 1: US imports are now flat


Exhibit 2: the diminishing import traction from the US domestic cycle


The international integration of supply chains may play a role here. “Physical” exports and imports follow the global cycle, while the more services-intensive components of demand can follow idiosyncratic, national developments, at least transitorily.

This means that for the export-dependent countries, diversifying their markets does not necessarily provide a lot of protection. German exporters used to focus on China as an “insurance” against a decline in demand from developed markets. But if the demand for tradable goods synchronises, then there is “nowhere to hide”. This is made even worse by the fact that the most important global macro headwind – the trade war – is not a zero-sum game, with losers and winners, as the US administration seems to believe, but a negative sum game, in which all participants lose some steam.

We illustrate this in Exhibit 3, where we look at the correlation between US and Chinese imports (excluding oil), over 1990-2007 and then after 2011 (we take out the global recession/rebound of 2008-2010 which would skew the estimation). The US and Chinese import cycles are much more clearly correlated in the recent period.


Exhibit 3: A tighter link over time between the US and Chinese import cycle


The US, the Euro area and the policy inversion

In Macrocast we have been suggesting that in principle Europe should respond with a fiscal push, while the US should respond with a monetary stimulus. We find it interesting that the Federal Reserve (Fed) is sounding a bit “hesitant” while a fiscal package was at least “discussed” at the White House.

To some extent, the Fed’s hesitation may just be a “calendar accident”. This week we had the minutes of a Federal Open Market Committee (FOMC ) meeting which took place before Donald Trump’s decision to slap a 10% tariff hike on China, and the hawks chose to speak. In his opening statement to the Fed conference in Jackson Hole, Powell did not explicitly embrace the need for further cuts, but starting his speech with the difficulty for monetary policy to achieve its mandate when neutral rates are low should be read, in our view, as an indication of the Fed’s readiness to act (if a central bank has limited scope for action, it should act faster than usual). Given the further accumulation of risks since the July cut, his repeated mantra that the Fed will “act appropriately to sustain the expansion” is normally consistent with more cuts ahead.

By another calendar accident, the possibility that the US administration would engage in further tax cuts coincided with the release by the Congressional Budget Office (CBO) of a new forecast for the US fiscal trajectory. The federal deficit is now expected to reach 4.5% of GDP for this fiscal year (from 4.2% in their May outlook), up from 4.1% last year. Relative to their outlook published in May 2019, the CBO has added a total of USD809bn cumulatively on the deficits over the coming decade. While the CBO publications may not have a strong impact on the public, two of their figures might: the deficit would exceed 1 trillion dollars in 2020 for the first time ever, while public debt/GDP would reach at the end of the next decade its highest level since just after World War 2. This strengthens our view that “policy inversion“ in the US – with fiscal contributing more than monetary to a rebound – is unlikely.

Indeed, these sobering CBO forecasts may well dampen political enthusiasm for any fiscal stimulus, even in the run-up to the presidential elections. This is one of the reasons why we think the Fed will have to cut further. Yes, a lot of the current headwinds are purely politically-driven and could thus be reversed very quickly (if we wake up in the next few months with a comprehensive trade deal between the US and China the global macro picture will change). This understandably makes some FOMC members uncomfortable with providing support to an economy which is not endogenously slowing down, but ultimately, the Fed is the only game in town.


The disappearing European risk-free asset

While the US may be faced with a sea of treasury issuance in the next decade, if nothing changes Europe is faced with a dearth of risk-free assets. We provide in Exhibit 4 an illustration of what would happen to German public debt if we keep the key parameters unchanged for the next 20 years: trend nominal GDP growth at 2.5% per annum (real growth and inflation at 1.25%), the primary fiscal balance kept in % of GDP at its level of 2018, and the average interest rate on debt gradually converging towards the current yield on 10-year Bunds. German debt would entirely disappear in twenty years.


Exhibit 4: the disappearing German public debt


Of course, these “parameters” will change. Interestingly there was a similar “risk free asset scare” in the late 1990s in the US, when the federal government was running surpluses. The whole question disappeared from the radar when the US government completely reversed its fiscal stance when the dot com bubble burst in 2001.

Still, low expected availability of Bunds today matters for the design of monetary policy. The European Central Bank (ECB) argued that when it comes to quantitative easing (QE) the “stock effect” trumps the “flow effect”. But obviously the “stock” – the quantity of Bunds already held by the central bank – needs to be measured against the expected overall quantity of Bunds. If investors count on a growing difficulty to source the risk-free asset, then even a quite small quantum of additional purchases by the ECB would have a significant impact on yields, especially against the background of a deterioration in the macro outlook which would in any case trigger stronger than usual demand for risk free assets. This would be consistent with our expectation that in September the ECB will opt for a fairly small quantum of additional QE (€25/30bn per month for six months) – allowing for continued compliance with the “limits”, as we suggested in Macrocast #9 – on top of a 10 basis point deposit rate cut.

We continue to be circumspect about the power of an additional monetary package though. Cutting rates across the curve further in negative territory when (i) there is no blatant sign of a supply-side restriction in lending to the economy and (ii) expected demand is down mostly on account of external shocks, is not going to boost growth much.

QE 2.0 would be dwarfed by a fiscal stimulus. A key issue when it comes to the German fiscal stance is to assess whether a political decision to do so – although the signs are far from blatant today – would be severely curtailed by the national institutional setup. Bank of America Merrill Lynch (BAML)’s Evelyn Herrmann produced a very timely and thorough analysis of this this week.

Her main point is that the “black nil” – the rejection of an overall deficit – is a political constraint, but that the “debt brake” allows some transitory leeway, even beyond the normal operation of automatic stabilisers, in case of “extraordinary circumstances”, as long as some precautionary saving previously has lifted a notional “control account”. In her calculation, the German government could engage in a transitory discretionary fiscal push of up to 2.6% of GDP.

The political hurdles remain significant though, as highlighted by BAML. Clearly, the institutional rules make the fiscal push possible but hardly pre-emptive. Things need to be “truly horrendous” to get there, and while a debate has started, we are not holding our breath.


Italy: never say never

We will come back more precisely to the Italian situation next week, but at this stage we think the spread tightening in reaction to the decision by the President of the Republic to give more time – until Tuesday – to find an alternative coalition is a reasonable move.


Investors had often considered that in the current coalition, 5 Star was the most unorthodox on economic issues, while Lega, with its roots in the North of the country, would always end up being more “reasonable”. Actually, the most Eurosceptic noises under the coalition came from segments of Lega. In addition, the tax cuts advocated by Lega are not necessarily easier to fund than the expenditure boost demanded by 5 Star. Finally, early elections today, judging by the polls, could give an absolute majority to Lega and Fratelli d’Italia, without the need – and the moderating influence – of Forza Italia.

It is unlikely that a technical government supported by 5 Star and the Democratic Party (PD) could or would do much on the structural reforms Italy continues to need, but at least a confrontation with the EU on the budget bill for 2020 could be avoided. Of course, taking the long view, an unpopular budget supported by 5 Star and PD could ultimately boost the anti-establishment fractions within Lega and ultimately lead to an even bigger success for them in subsequent elections, but at least we may have a respite, and given the number of things which could go wrong in the global economy at the moment, any respite is good.

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