ECB: waiting for the strategy review

Watch the American consumer

Our narrative on the US economy is relatively simple: for now, while the export-driven side of the economy is struggling, and investment in general is impaired by looming uncertainty with the “trade war” at the top rank of risks, the more sheltered, domestic-led sectors continue to grow at a decent clip. Since the latter is more dominant in the US than in most other developed economies, on aggregate cyclical conditions in the US are not yet consistent with a major downturn, especially with some support coming from a more accommodative monetary policy. But should the external shock start to percolate to the domestic economy, the outlook will significantly deteriorate.

This is why getting resolution as quickly as possible on the trade war is so crucial. For now, the tariff hikes did not raise input costs much. This may change by the end of the year if, in the absence of progress in the talks with China, suspended tariffs are implemented, this time hitting directly consumer goods.

Another risk to keep in mind though is that US consumers become more cautious even before the trade war actually hits them. This is in that light that last Friday’s batch of US data was so interesting. New orders of non-defence capital goods excluding aircrafts – the best high frequency proxy for corporate investment in the US – disappointed again in August, falling by 0.2% mom (the market was expecting a stabilisation), with July being revised down from 0.2% to zero. This continues a concerning trend. Indeed, to look through the noise we like to look at it on a year-on-year basis, smoothed over three months. According to that metric new orders are now in contraction territory, for the first time since early 2017. But the market focus on Friday was more on the disappointing data for household consumption, which grew by 0.1% (0.2% expected) with a downward revision for July as well.

It is always dangerous to read too much in a single data batch, and in the case of consumer spending weakness is very recent and not part of a trend. Using the same approach (yoy change smoothed over 3 months) US household consumption is still on the 2.5% pace observed since the beginning of the year. But we need to monitor this specific variable very closely in the months ahead. At this stage the US consumer is one of the very few functional engines in the world economy. If it comes to sputter, there is no obvious alternative and talks of a “mid-cycle breather” will sound increasingly out of step with reality.

ECB: tricky “strategy review” ahead

We knew that the European Central Bank (ECB) was very divided in the run-up to the Governing Council meeting on September 12th, but two weeks later the fallout of what must have been a very fractious discussion is still very much here.  The latest examples are Banque de France’s Governor Villeroy de Galhau revealing publicly he was opposed to resuming quantitative easing (QE), and board member Lautenschlaeger announcing her resignation by year end. News of dissent will further dampen the psychological, confidence-boosting effect of the last batch of ECB easing, but the crucial issue is obviously how this will affect the ECB’s monetary stance once Christine Lagarde takes over in November. From that angle, we  think any consequences may take until the middle of next year to emerge.

Let us deal first with the personnel changes. Two board members will need to be replaced at the beginning of next year: Benoit Coeure (who is reaching the end of his term) and now Sabine Lautenschlaeger. Benoit Coeure was widely reported to have opposed the resumption of QE as well (he disagreed with the timing according to the Financial Times on Friday). The only candidate for his replacement declared so far is Fabio Panetta, from Banca d’Italia. Although he has been focusing on banking issues for quite some time so that his views on monetary policy have not been aired often, we would rank him as more dovish than the Frenchman. Sabine Lautenschlaeger was on the far end of the hawkish spectrum. Even a replacement coming from the Bundesbank is unlikely to “out-hawk” her. It is thus not obvious that the general stance of the board will change that much.

In the meantime, the central bank can hardly make any new decisions before it has had enough time to assess the impact of the September package.  Tiering will start only at the end of October, and quantitative easing in November. Some technical decisions will need to be made by then – in particular the breakdown of the asset purchases between the public and the private sector - but nothing crucial. We also think that the ECB will be reluctant to consider it can effectively assess the full effect – and potential shortcomings – of its September package before the results of the next Targeted Longer-Term Refinancing Operation (TLTRO) in December.

By that time, the ECB will have a new boss. Draghi lost no time to make his mark on monetary policy, cutting rates on his first Council meeting as President. But he had been in the room for several years as Governor of Banca d’Italia.  At her confirmation hearing to the European parliament Christine Lagarde pledged to conduct a thorough strategy review of the ECB’s monetary policy. She may want to wait for the completion of this process before altering the current stance of the central bank. If history is a guide, the ECB likes to take its time when re-thinking its strategy. Last time it did, the process ran from December 2002 to May 2003, and we would argue that monetary policy was a walk in the park then relative to what it is now. The issues are more complex, and the array of choices much wider and controversial today. Assuming the review is launched at the end of this year, once the new President is in, we would be surprised to get hard decisions before mid-2020.

This is where, by the middle of next year, the backlash from the September package could hit. We think that anyway the central bank had used up its arsenal even under Draghi already. We made the point several times before: the crucial decision is on the “technical limits” to QE. The ECB’s latest package contained the maximum monthly quantum of bond buying consistent (just) with not removing the 33% limit on national central banks’ holdings of marketable public debt. If even this compromise approach was so contentious that Draghi himself did not manage to build a wide consensus around it, it would take a properly disastrous macroeconomic situation to tilt the ECB into pushing those limits. Given the mood at the Governing Council, the bar for this is probably higher today.

The ECB may face a credibility issue if by next summer, having completed its strategy review, inflation has not converged towards its target, but additional action is de facto impossible. The risk then is that the strategy review becomes a case of reverse engineering, in clear changing the definition of the inflation target (for instance with a range), to justify the practical impossibility for monetary policy to do more.  

Of course, good news could come and help the ECB out of its current predicament. If we get a fast resolution of trade war and the world economy re-starts fairly quickly from the start of 2020, there may be a temptation at the Governing Council to put an end to QE after only a few months, to heal the divisions, provided core inflation accelerates a bit to justify such a move from a macroeconomic point of view. We think that in those circumstances the central bank would have to revise its forward guidance, so that the market does not start anticipating rate hikes too soon. But again, none of this is for immediate consumption.

Is the German economy drifting away from the Euro area?

While the ECB is reaching the end of its capacity to stimulate, it remains absolutely crucial to the swift functioning of the European financial system. When discussing last week the potential issues the ECB’s tiering of its deposit rate had created for the short end of the curve we mentioned that cash-rich banks (mostly in the North) had to lend to the cash-lean banks (mostly in the South). Beyond the technical point we remain concerned, seven years after Mario Draghi’s “whatever it takes” speech, by the degree of balkanisation of the European financial system. In spite of “banking union”, banks have retreated to their national turf and it’s the ECB’s liquidity which keeps it together.

In Exhibit 1 we look at German credit institutions’ interbank exposure to the rest of the Euro area via loans.

The recent rebound has been timid and, while for a short period between the demise of Lehman Brothers and the beginning of the European sovereign crisis exposure to the Euro area has almost been on par with that to the rest of the world (reflecting we suspect a willingness to re-risk from US counterparties), as of today exposure to non-Euro area counterparties is twice as large as to Euro area ones. Low intra-Euro exposure of German credit institutions via interbank loans has been to some extent offset by purchases of Euro area debt securities (in Exhibit 2 we look at government and corporate debt together), but this has diminished as well since a peak in 2009, and the “hump” around 2015/2016 would suggest that German banks have taken advantage of QE to de-risk again from other Euro area issuers.

Exhibit 1 – German banks cut their exposure to Euro area banks…

Exhibit 2 – …and more generally to the Euro area financial markets

This is part of a more general trend which goes beyond the banking system. The Euro area has been attracting less than half of German outward direct forward investment for years (the share in the outstanding volume is now below 40%), while nearly 60% of German exports are directed to non-Euro area markets (see Exhibits 3 and 4). In a nutshell, while the policy debate in Europe is currently focusing on how to convince Berlin to engage into a fiscal push which would benefit the entirety of the Euro area, the German economy has seemingly become less dependent on European affairs.

Exhibit 3 – German corporates moving away from the Euro area for investment…

Exhibit 4 – …and exports

This is largely an illusion though, since the decline in the sensitivity of the German private financial institutions to the Euro area risk has been made possible only by a growing involvement of the German public sector. The flip-side of the “renationalisation” of financial activity since the crisis has been the huge rise in the ECB’s balance sheet – to which the Bundesbank is obviously very sensitive given its massive claims over the ECB – together with the creation of the European Stability Mechanism, with Germany has its biggest guarantor.

Still, the dichotomy between the private and public sector in terms of sensitivity to economic and financial developments in the Euro area may inform the attitude in Berlin towards any “additional step” in making the Euro area more complete, in particular in the form of fiscal union. Indeed,  the economic momentum in Germany is increasingly driven by developments outside the Euro area. Demand expectations from China and the US probably dominate, while the bulk of the foreign production capacity of German firms is located outside the Euro area. What happens in the Euro area matters more in terms of “credit risk”, and Berlin has shown time and time again that it was ready to act in case of existential threat to the monetary union. But the German government may not be so keen to act when the “only” problem in the Euro area is a cyclical downturn.

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