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STATE OF AFFAIRS
Notwithstanding that the past week gave little direction as informative economic newsflow was lacking, the September 10 ECB meeting delivered food for thought. The 20 page document titled “ECB staff macroeconomic projections for the euro area, September 2020” summarises in a condensed fashion the monetary, fiscal and labour market framework that drives ECB policy making until December 2020. In December a new set of forecasts will get assembled shaping ECB decisions over the first quarter (Q1) of 2021. The question I raise is “Why did the ECB turn complacent during last week’s ECB gathering?” Market observers might simply reply that next meeting, on October 29, will be a live meeting where more accommodation will be delivered. All good and well, but why spoil opportunities? My contention is that the ECB should be more pre-emptive instead of reactive. The ECB is not sensitive enough to negative feedback loops that more often than not become sticky once the damage has been inflicted. Especially inflation and investment channels get clogged because of ‘too little too late’ attitude in announcing policy initiatives. Whilst implementation is faultless, signalling and pre-emptive quality is poor or non-existent. The latest economic projections document is a point in case. We’ll focus on inflation and the impact of the EUR strength. Two items that feature prominently in the document but leaves the reader with a sentiment of….” Why wait? All the evidence points to underachieving/underdelivering on policy objectives!”
The projection period goes out to 2022. Next to a baseline scenario, the ECB staff provides a mild and a severe scenario. The trajectory within the baseline scenario for Harmonised Index of Consumer Prices (HICP) inflation gives an inflation print of 0.3% for 2020, 1.00% for 2021 and 1.3% for 2022. Over their projection period, they do not deliver on their ‘2% or just below’ inflation target. Moreover, Philip Lane as chief ECB economist, and highly influential towards ECB President Lagarde, stated in a presentation end of August that the COVID-19 health crisis has been deflationary and important monetary stimulus is required to raise the inflation path. Underdelivering might lengthen the path towards the official objective by 2 to 3 years. Clearly, ECB staff must not be impressed by negative 0.5% deposit rates, EUR 1.3 trillion in bank funding given at a rate of -1.00% and over EUR 1.5 trillion in asset purchases that will impact till Q2 2021 and be reinvested till end of 2022. Even in the face of such stimulus, the ECB does not honour their mandate. Fiscal policy effort across the Eurozone amounts to 4.5% of GDP over 2020. Partial or total government guarantees amount to 20% of GDP in order to alleviate liquidity constraints for large and small businesses. The EUR 750 billion Next Generation European Recovery Fund (NGEU) will provide member states with additional fiscal power to buffer the shocks in demand, investment and supply. Apparently to no avail with respect to inflation, as in the severe scenario inflation grows by a mere 0.7% by the end of 2022. The mild scenario is built on the assumption of a vaccine breakthrough by the end of 2020, early 2021. 2022 inflation would hit 1.8%. The latter carries a low probability. If AstraZeneca’s Phase 3 clinical trial bumps in only 1 other victim with negative side-effects, they can fold the whole program. So they fear HICP inflation between 0.7% and 1.3% taking into account all of the above stimulus. More stimulus is required if the ECB wants to preserve its current credibility level. The Bank of Japan underdelivered and missed on their inflation target persistently. That attitude was fatal to Japanese inflation expectations across households, corporates and financial markets. Japanese inflation expectations are 0% over the next 10 years. Zero. Inflation has become irrelevant in the land of the rising sun. The baseline estimates that end of 2022 Eurozone GDP will still be 3.5%, below end of 2019 levels. With the current policy mix we might hit pre-COVID 19 output levels by 2024 or 2025? The mix lacks confidence.
Inflation remains low over 2020 because of the hit in oil over the first half of 2020, German VAT tax cut and EUR strength. The projections for the EUR-USD exchange rate go from 1.14 over 2020, 1.18 over 2021 and 1.18 over 2022. The June projections stood at 1.09, 1.08 and 1.08 over the same horizons. Just as inflation will undershoot on objectives, the EUR-USD seems to break-out above 1.18, the level they predict will prevail till 2022. We detect the same behaviour and attitude. The EUR-USD will need to hit 1.22 or 1.25 before the ECB will act. However damage to economic agents, especially exporters, will have been realised. On September 1 the verbal intervention by Philip Lane pushed the EUR-USD from 1.2010 back to 1.1800…We closed last week around 1.1830. Notwithstanding, the September 10 meeting has been a wasted opportunity to lead. Why wait to lower the deposit rate by 10 basis points (bp) or more? Protect the banking channel by raising the multiple from 6 to 9 on minimum bank reserve requirements in order to exempt more bank excess liquidity from the negative deposit rate? The signalling function at -0.5% is apparently not powerful enough. Money supply growth in Europe at around 10% Year over Year (YoY) lags the US money supply growth by 15% points! US M2 money supply grows at a rate of 25% YoY. That is reflation. It is visible at the level of real economic indicators as within financial markets. The ECB was too slow to act in response to the Great Financial Crisis in 2008. Will they make the same mistake in 2020? Philip Lane posted in his blog “It should be abundantly clear that there is no room for complacency.” I’m not getting excited though by what I observe and when I read such statements.
As US equity markets have not been able to find solid ground since the start of September. An increasing number of investors have raised their US Treasury exposure or close their short base. Especially in 30 year Treasuries according to the latest Commodity Futures Trading Commission data tracking rate derivate exposures. The 30 year closed at 1.41%, down 6bp over the week. The 5 year and 10 year notes dropped 5bp towards 0.25% and 0.67% respectively. Interest on the 2 year note was solid, closing at 0.127%. Expect 2 year notes to test the end of July lows of 0.105% in the coming weeks. Market participants are preparing portfolios for the October Q3 earnings test in the US next to the Presidential elections on Tuesday November 3. Two events that call for prudence and might increase risk aversion at the margin. Expect supportive Treasury markets till early November. Consider next Wednesday’s FED meeting as the kick-off.
EMU rate markets have become numb. German 10 year rates closed at -48bp, down 3bp on the week. Interestingly EONIA 1Y1Y forwards closed at -0.56%, potentially indicating that a test of -0.60% is in the offing. That would open the discussions on adjustments of the deposit rate facility from -0.50% towards -0.60%. The EUR-USD is sensitive to such changes. A drop in policy rates would have a high signalling effect and steepen the German curve as the ECB’s reflationary objective gains credibility. The German 10y30y might steepen towards 50bp to 60bp range (currently at 44bp). Correlation informs us that such a condition requires the EUR 5Y5Y inflation swap forwards to advance towards 1.30%-1.40%. Currently, these sit at 1.20%. The ECB cannot let this indicator test the 1.00% level once more. On the intra EMU rate convergence front, all is under control. The PEPP program is effectively reducing fragmentation. PEPP will need to run over 2021 and beyond.
European Investment Grade corporate bonds passed a fairly uneventful week, coloured by a vibrant primary market. The Iboxx index dropped 5bp in return, and has held on to a positive Year to Date (YtD) result of 0.75%. EUR High yield added a shallow 6bp to performance over the week. YtD, the European high yield sector still recovered, but at a slower pace, ending the week at -1.48%.
Mixed performance of Emerging Market (EM) debt during the week. Local currency debt spreads (GBI-EM index) widened by 3bp to 3.80%, while external debt spreads (EMBI GD index) tightened by 7bp to 4.14b%, above global aggregate bond yields. This good performance of hard currency debt is entirely due to Latin America, whose spreads tightened by 43bp when spread of all other regions widened between 9bp and 17bp.
EM debt seems relatively immune from the recent volatility seen in other risk assets. Actually, fund flows show there was a stronger demand for EM risk (both bonds and equities) than developed market risk last week. Flows into local currency debt funds also gained momentum, outpacing inflows into external debt funds for the first time since the end of January.
EM currencies (FX) performed positively versus USD (0.26%), but the rebound in EUR/USD weighed on unhedged returns in EUR (-0.36%). The Mexican Peso (1.14%), the Hungarian Forint (0.82%) and the Russian Rubble (0.50%) were amongst the best performers, while the Israeli Shekel (-2.75%), the Georgian Lari (-1.39%) and Indonesian Rupiah were amongst the worst performers versus the EUR. In Indonesia, a rebound in COVID-19 infections and lockdown of Jakarta (contributing to 20% of the country’s GDP) weighed on the performance of local equities, bonds and the Indonesian rupiah. The South African Rand lost 1.08% during the week, and exhibited a lot of volatility on the back of worse-than-expected Q2 GDP figures (-51% annualized quarter on quarter) and current account deficit (-2.4% of GDP versus -0.4% consensus). This made markets starting to price in another 25bp cut to the repo rate by the SARB Monetary Policy Committee at next week’s meeting. In Latin America, COVID-19 seemed to be peaking even amongst laggards. Considering that steeper infection curves have weighted on Latam FX during the last quarter, and the arrival of spring season in the Southern Hemisphere, we can expect – other things being equal – stronger currency performances. Positive economic surprises in the area will become supportive.
The ECB has room to provide more meaningful monetary impulses to the Eurozone economies. Its reaction function should become pre-emptive instead of remedial. With a stronger EMU construct, since the July 18 historic accord on NGEU and the start of joint issuance as of 2021, in place the ECB should lead in central bank policymaking. The US FED and the US Administration are once again better in sync and more aggressive to face current challenges.
Last week we stated that central bank purchase programs lift inflation expectations. That is true, but for the Eurozone, current efforts will not be enough. Other policy levers will need to be adjusted. From cutting the deposit rate over increasing the multiple on minimum bank reserve requirements, protecting the banking system better from the punitive negative deposit rate treatment to flagging a continuation of the PEPP program over 2021. Other options can be studied. Fact is that the ECB staff economic projections call for action today and not tomorrow.