Q2 Outlook: Europe has the most to lose and most to gain

Europe is in a potential lose-lose situation as we await the outcome of the US-China trade negotiations. The friendlier the deal, the more likely that China could shift some of its import demand away from Europe and towards the US. With or without a friendly deal, risks point to ongoing de-globalisation and a growth slowdown that would be double trouble for the European Union, the world’s largest trade surplus economic bloc.

As Europe stumbles towards recession later this year or early next year, the old existential questions will inevitably rise once more to dog the EU political and financial landscape. In short, Europe deserves a considerable portion of our attention as Q2 will inevitably prove an important pivot point for the EU. Either we see escalating signs of further dysfunction or a more determined shift by EU governments to get ahead of the risks of rising populism and the unworkable fiscal/ European Central Bank foundation of the EMU.

Fortunately for Europe, the EU economy would be the most receptive economy to a financial sector house cleaning and fresh fiscal impulse, given widespread austerity. But unfortunately, the dysfunction of multiple sovereign fiscal authorities using the same currency and same central bank persists (i.e. everyone is essentially funding themselves in a foreign currency – for better, as with Germany, or for worse as on the periphery).

Worse still for the ECB is that the extend-and-pretend option is simply no longer available. Interest rates are already negative, leaving no policy room there. As for balance sheet expansion, with a balance sheet of some EUR 4.7 trillion, the ECB can’t simply lurch back into quantitative easing, at least not under the former “capital key” rules of its 2015-2018 QE, under which it was required to purchase sovereign bonds in proportion with each EU member’s GDP.

One key case in point is Germany: there simply aren’t enough German bunds available on the open market to buy as German outstanding debt is too small and the country continues to shrink that supply with fiscal surpluses.

Another challenge for Europe is that it is perhaps the least well-positioned economic bloc for the global slowdown we see coming. When the global economy goes into a soft patch or worse, it is the surplus economies most leveraged to global demand that suffer the most. Given that Europe is the only major economic bloc running a large aggregate surplus, it – and Germany in particular - is particularly poorly positioned for a global growth slowdown, as we already saw in the second half of last year when Q3 German GDP dipped into negative territory and Q4 GDP registered a flat, 0.0% quarter-on-quarter rate.

If the global economy goes from slow to worse, Germany is likely to find itself at the epicenter of any EU recession.

How Europe will deal with recession and existential threats – particularly given that the core economies may suffer the worst stresses as we outline above –over the rest of 2019 and into 2020 is uncertain. In that light, key political changes are on their way this year: EU parliamentary elections are up in late May and offer the next key test of the rise of populism. Although the populists don’t speak with one voice, coming as they do from all across the traditional political spectrum, they could still prove a disruptive force.

Rest assured, however, that the pro-EU forces have a plan; the political and ECB handover after the May elections will bear close watching on that front. The likely new chief economist at the ECB, Ireland’s Stephen Lane, is strongly pro-EMU and has a portfolio of plans for deepening EMU capital markets with a European “safe asset” – some kind of semi-mutualised bond and even something called sovereign-bond-backed securities, or SBBS. But that’s just a plan for the plumbing – the real test is structural and one of political will as the EU’s government heads would have to make the commitment to mutualise at least a solid portion of their sovereign balance sheets to realise this vision.

Given the election cycle, 2019 is the pivotal year for putting new key EU figures in power, including the new ECB head later this year and new heads of the EU Council and Commission.

The nominee in waiting for the ECB presidency could become clear in Q2, but with central bank policy from here likely taking its cue from fiscal forcing, the political side of the equation may weigh far more. Down the road, a deeper and more integrated EU capital market would provide a strong fillip to the euro, but will the coming EU political leadership have the will to go there? The euro could struggle to rally until a path towards EMU deepening opens up. The alternative is too complicated to discuss here, but doesn’t necessarily mean a weak euro if the end result is that some of the periphery achieves devaluation by partial funding in parallel new currencies rather than exiting the EMU.

Our key theme for Q1 was the great “policy panic” as central banks reacted to the ugly deleveraging tantrum of Q4’18. That panic is now complete, as our CIO Steen Jakobsen wrote in his macro outlook just after the March Federal Open Market Committee meeting. First it was the Bank of Japan and the ECB, but now they are joined by the Fed throwing in the towel on the attempt to normalise policy. In the case of the Fed, we still have the end of balance sheet tightening to taper and stop and a couple of hundred basis points of rates to cut, as well as plenty of room for restarting QE, given the excess of US Treasury supply from President Trump’s huge deficits. But because such a move toward an easier Fed stance would likely coincide with increasingly weak US growth and deleveraging markets, the shift to a weaker dollar may take some time this year.

Elsewhere, our least favourite currencies in a weakening global growth environment are the commodity dollar currencies, where housing bubbles are in various stages of unwinding, inevitably impacting the credit and therefore growth outlooks. Our longer-term bullish call on commodities should eventually offset downside risks, but these risks will prevail until central bank policy in these countries looks like it does for the rest of the DM – i.e. more or less ZIRP and central bank balance sheet expansion to clean up the private credit mess.

Growth risks remain a concern for emerging markets, but we think China provides a backdrop of stability as it seeks to maintain a stable currency and attract capital inflows to deepen its capital markets and accommodate its transition to becoming a deficit country (a key step in shifting the CNY to an eventual reserve asset). The JPY could do well during bouts of risk deleveraging this year, but the Japanese government is perhaps the most ready to switch on the fiscal stimulus, with the BoJ happy to cooperate as it seeks to avoid yen volatility.