Plan B, C, D...,Z
- For now the impact of the COVID-19 epidemic on the global economy is mainly taking the form of a supply-side shock, but the emergence of an autonomous contagion point in Italy is a change in dimension. We also keep an eye also on what could be an idiosyncratic soft spot in the US.
- Policy stimulus is more suited to dealing with demand driven shocks, but we discuss here options for the European Central Bank. We think raising the quantum of corporate bonds purchases would be a decent response. Sovereign spreads need to be “closely monitored” by the ECB though.
- The negotiations on the EU budget illustrates how difficult it is to get swift policy action in the current environemnt.
Supply-side shock (for now), but Italy changes the picture
We started our Macrocast last week with the news that the Chinese authorities had changed the way new covid-19 cases are counted in Hubei, and we would need to start with the same point today, with a second tweak to the case-recording system. This makes our concern even more valid that most of the epidemic projections so popular in the market are now obsolete. However focus is now shifting to the propagation of the epidemic outside China. The emergence of an autonomous contagion point in South Korea, in a city where 5% of the national population lives was from this point of view already concerning. The steep rise in the case count in Italy (>150 as we write these lines) is another bad signal. This makes the reports on Sunday of pressure from the Chinese government on businesses to re-open less relevant, in the sense that we might see the beginning of some normalisation in Chinese output (assuming, and it is a big if, that relaxing the curb on travel does not trigger another epidemic wave…) coinciding with some idiosyncratic difficulties in other markets.
Before we discuss Italy let’s focus on the global macro picture. We are now getting a trickle of soft and hard data which can help us gauge the global economic impact of the crisis. So far and very tentatively, it seems that supply-side disruption is emerging before demand-side effects kick in.
South Korea has released its foreign trade data for the first 20 days of February and reassuringly total exports did very well with a 12.4% year-on-year (yoy) growth – although this was boosted by a higher number of working days in the month. But at the same time their imports from China fell by a whopping 18.9%. This a clear signal supply chains are under stress.
The same applies to the Euro area. At face value the unexpected rebound in the German manufacturing Purchasing Managers Index (PMI) in February was also reassuring, but half of it came from a statistical artefact. There was a steep rise in “suppliers delivery time” which mechanically raises the overall index because it is normally a signal of “overheating” (suppliers finding it difficult to cope with demand). This time it reflects the disruption in supply lines triggered by difficulties with Chinese components (this was explicit in the qualitative comments released by Markit, the producer of the PMI index).
The sudden rise in covid-19 cases in Italy changes the picture for the European economy anyway. Indeed, the activity restrictions already imposed by the national and regional authorities will be implemented in some of the country’s most crucial regions in terms of output. Lombardy, Veneto and Emilia-Romagna alone account for 40% of Italian GDP and 6% of total Euro area GDP.
We suspect that – short of a swift resolution of the epidemic – the demand-side effects will emerge in the next batches of data. We think the early consensus of a swift “v shape” recovery is looking increasingly shaky. Last week we highlighted the fact that the dataflow in the US had not been stellar since the beginning of the year, with weak retail sales for instance, while so far consumer spending had been the bedrock of US cyclical resilience. Evidence of this “soft start to 2020” in the US is accumulating, with the Markit services PMI falling in contraction territory to 49.4 from 53.4 in January, well below expectations of 53.4. True, the market’s preferred indicator of this nature in the US is the ISM version, but everyone – your humble servant included - is counting on the US relative insensitivity to Eastern Asian demand to provide support in the first half of the year. If this is wrong, we have a big problem on our hands.
We were more cautious than most on the global outlook before the epidemic. We are happy to remain below consensus now.
The supply-side issues are problematic in their own right since they are much less “treatable” with a policy stimulus. Yet, we suspect that to a large extent the resilience of the financial markets so far hinges on the expectation of some policy support. In a sense this is rational: while more central bank liquidity and/or lower rates may not re-start an economy if it is primarily dealing with supply disruption, it would still affect asset prices.
Until now, the European Central Bank (ECB) could fairly easily deflect questions on how it would respond to the ncov-19 headwind by borrowing from Jay Powell’s words last week, expressing a willingness to monitor the situation while refusing to speculate on how long and how deep the drag from Eastern Asia is likely to be. Bullard was even more explicit on Friday, re-stating that the Federal Reserve (Fed) was “in a good place” right now, thus maintaining the Fed mantra that their pre-emptive stimulus last year is already providing a nice degree of insurance. This has not prevented investors from pricing significant additional accommodation from the Fed (Exhibit 1). One month ago, market pricing had the Fed cutting by less than 25 basis points (bps) by the end of January 2021. It is now pricing nearly 50bps, with the first cut materialising by the summer of 2020 (Exhibit 1). Our own (pre-epidemic) baseline was 50bps worth of cuts at the end of the year.
Last week a speech by ECB Vice-President de Guindos still conveyed a level of cautious optimism, highlighting the improvement in the dataflow in the last few months and presenting the coronavirus crisis as an additional risk to a balance already tilted to the downside rather than an issue which should already affect the central bank’s baseline. Philip Lane, the ECB’s Chief Economist, went as far as stating explicitly in an interview with Bloomberg on Friday that the central bank’s base case was that the epidemic would produce a “v shape shock” which would not warrant an immediate reaction from the central bank. This is “brave” in our humble opinion. Still, even before the news broke of the epidemic spreading in Italy we are convinced that the staff in Frankfurt was already engaged in contingency planning, and the fact that de Guindos chose to conclude his speech by repeating the ECB’s line on their readiness to act if need be, irrespective of the “strategy review”, was interesting . We look here at the likely options.
The market is already pricing a two third probability of another deposit rate cut by the end of the year (see Exhibit 2). That is an understandable reaction to the ECB’s forward guidance – they “expect policy rate to remain at their present level or lower” – but given the increasingly ambiguous effect of such a move we think the bar for such action is quite high. The least disputed impact of cutting the deposit rate would be a currency depreciation. It could be tempting to offset a drag on the volume of foreign demand by reducing the price of exports. However, this is what the market is already spontaneously generating with a 3% decline relative to the dollar since the beginning of the year, which has accelerated since the day the Chinese authorities imposed travel restrictions in Hubei (Exhibit 3). And obviously if the Euro area now needs to deal with an internal source of demand compression (Italy), manipulating the currency makes even less sense.
Renewed expectations of an additional ECB rate cut may have contributed, but we suspect what is happening is more a generic rally in favour of the dollar given the US’ lesser sensitivity to Eastern Asian demand. Indeed, the euro’s depreciation relative to a basket of 12 currencies has been significantly lower than that of the bilateral euro-dollar exchange rate. The current configuration is more consistent with a “strong dollar” than with a “weak euro”.
Given the sensitivity of the US administration to anything that looks like “currency manipulation” we could not discard the risk that another depo cut would be met with additional stress in the US/EU already tense trade relationship. This would only be one of the “side effects” of taking rates further into negative territory. Although the ECB’s chief economist Philip Lane stated publicly two weeks ago that it is “clearly not the case” that we have reached the “reversal rate”, we think a majority of the Governing Council is very reserved about additional cuts, even with more “tiering”.
Would quantitative easing (QE) be in play? Those who opposed or had reservations on the September package often justified their position by arguing long term interest rates were already very low. The same would apply today, with the German 10-year yield already back below -0.4% and Italian 10 year yields under 1%. We suspect that those yields would have fallen further by the time the ECB decides to provide some additional accommodation. Given the very sensitive political nature of purchasing sovereign bonds and the lack of space before the central bank hits its limits there, we think the ECB will look at all other options before agreeing to another uptick on this leg of QE.
The only scenario where we could see the ECB quickly drawn into more action on government bonds is one in which sovereign spreads would start rising in some countries, and obviously Italy is a natural candidate for that. Beyond the potential economic cost of the epidemic there, we would mention the possibility that the domestic political situation sours, with the management of the covid-19 crisis being used by the opposition against an already fragile coalition. This is consistent with a rise in Italy’s risk premium, everything else equal, even if our contention is that the mere possibility of ECB action would act as cap on market movements. As an extreme solution, we could see here some justification for the ECB to diverge more from the capital key to provide temporary relief to the Italian bond market, but we are not there yet.
We think there could be a good case to make in favour of raising the quantum of monthly purchases of corporate bonds.
First, it is less politically and technically challenging. Indeed, while the ECB cannot (at this stage) buy more than 33% of the eligible debt of a sovereign issuer, the limit for corporate bonds is at 70%. Besides, the ECB is not bound by its capital key to apportion the purchases across the different national markets and can source the bonds directly (i.e. does not need to wait until they hit the secondary market). True, the initial universe (when the central started purchasing corporate bonds) was not massive, at EUR 600bn, given the European preference for intermediated funding. However, since then net issuance has been significant. Our estimate of net issuance so far into 2020 already stands at EUR 45-50bn for non-financial firms, of which probably two thirds are eligible. This must be compared with the current pace of buying (EUR4bn/month since the ECB re-started the programme), although the ECB has already significantly shifted QE towards corporate bonds (Exhibit 4).
Second, such approach may come handy if and when a pronounced slowdown were to trigger a tightening in financial conditions through a spread widening on riskier assets. Currently focus is on the possibility that the accommodative stance of the ECB is generating a speculative bubble in the riskier segments of the credit market. But precisely, a steep economic downturn raising the probability of corporate defaults could be the trigger which could make the bubble burst. More corporate bond buying by the ECB would take care of that risk. We would see this more as “avoiding an additional negative” than supplying a proper net stimulus to the European economy, but we are exploring contingency planning here, and quite frankly last resort action at a time when monetary policy is nearly exhausted.
We need to talk about banks though. Indeed, an extension of the corporate bond programme would probably accelerate the shift in corporate funding away from bank loans towards security issuance. This would leave banks with a shrinking market share, dealing with the smaller/riskier corporate borrowers, at a time of (we would expect) low overall credit demand. Another round of TLTROs would probably be useless in such a configuration, since credit institutions would have a hard time finding enough loan demand to comply with the programme’s conditions. We think there might be scope for some relaxation of those rules, for instance by allowing a fraction of the mortgage portfolio to be eligible to TLTRO refinancing.
European budget: much ado about 0.1% of GDP
The European summit tasked with “filling the budget gap” left by Brexit failed to come to any agreement. This is probably not very surprising. EU budget discussions have always been quite contentious, resulting in a series of “rebates” for individual member states which have blurred the picture. But obviously that the European member states cannot come to an agreement on a budget which is minuscule relative to national public finances (c.1% of the EU GDP, with the debate focusing, after the German/French mediation, on a mere 0.1% of GDP) is not a great signal on the possibility to do more on the EU’s expanding ambitions, on climate change or, in the case of the Euro area, on the emergence of a proper fiscal capacity. What we also find problematic is that all traditional political families in the EU are divided on these issues. Among the “Frugal Four” who have been arguing in favour of a “hard cap” on the budget we find Austria, run by a centre-right/green coalition, Denmark and Sweden, with minority social-democratic governments and the Netherlands, headed by a Liberal. Counting of swift fiscal support in Europe in the coming months is an optimistic assumption, in our view.
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