Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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Q2 Outlook: A reality check for the euro area
Christopher Dembik
Head of Macroeconomic Research
Summary: The problems facing the Eurozone economy are neatly illustrated by fresh German data showing soft exports and contracting factory orders. While Chinese fiscal stimulus should help get Europe’s biggest economy back on track, expansionary fiscal policy across the bloc, as well as interest rate normalisation, are also necessary to ameliorate the ills of the euro area as a whole.
There is no such thing as global decoupling. Unsurprisingly, headwinds from China’s slowdown are starting to hit Europe and the US. The Organisation for Economic Co-operation and Development’s euro area leading indicator, which is widely used by asset allocators globally, has fallen sharply over the past few months. The year-on-year rate stands at its lowest level since the end of 2012.
At the same time, large declines in core European industrial production data can be observed, especially in Germany, which accounts for one-third of European industrial activity. This slowdown came as a shock for many policymakers, but we feel that it was predictable. Over recent quarters, our leading indicators (notably credit impulse) led us to warn clients and investors against the risk of lower growth in Europe.
Low credit impulse and China
The euro area faces two main issues: low credit impulse and the Chinese slowdown. The euro area credit impulse, a key driver of economic activity, is running at 0.4% of GDP, which is rather low compared with its four-year average of 0.8%. A country-by-country analysis shows that the risk of growth decoupling between core countries and the periphery of the euro area is emerging again. In France and Germany, credit impulse is positive, at 1.7% and 0.6% of GDP respectively. By contrast, the credit impulse is sharply decelerating in the periphery; it was close to zero in Q4‘18 in Italy and sits at -2.1% of GDP in Spain, a level not seen since the end of 2013.
This tends to indicate that a more restrictive credit cycle, especially in the periphery, has started. This will have a negative impact on domestic demand as it is highly correlated to the flow of new credit in the economy, and ultimately on growth as well.
At the same time, large declines in core European industrial production data can be observed, especially in Germany, which accounts for one-third of European industrial activity. This slowdown came as a shock for many policymakers, but we feel that it was predictable. Over recent quarters, our leading indicators (notably credit impulse) led us to warn clients and investors against the risk of lower growth in Europe.
Low credit impulse and China
The euro area faces two main issues: low credit impulse and the Chinese slowdown. The euro area credit impulse, a key driver of economic activity, is running at 0.4% of GDP, which is rather low compared with its four-year average of 0.8%. A country-by-country analysis shows that the risk of growth decoupling between core countries and the periphery of the euro area is emerging again. In France and Germany, credit impulse is positive, at 1.7% and 0.6% of GDP respectively. By contrast, the credit impulse is sharply decelerating in the periphery; it was close to zero in Q4‘18 in Italy and sits at -2.1% of GDP in Spain, a level not seen since the end of 2013.
This tends to indicate that a more restrictive credit cycle, especially in the periphery, has started. This will have a negative impact on domestic demand as it is highly correlated to the flow of new credit in the economy, and ultimately on growth as well.
On the top of that, the euro area, which has been more and more reliant on Asian growth since the financial crisis, is hit hard by low economic activity in China. The two charts below show the drop in Germany’s export data; trade, which accounts for 46% of the country’s GDP, looks soft. Germany’s factory orders, at constant prices, are in contraction and close to their 2012 nadir. In other words, we are looking at a decline in the manufacturing sector months ahead as well as weak sentiment in the automotive industry. Digging further into the data, the most striking chart is German export growth to China, which has fallen sharply since the beginning of 2018 and is now in contraction as well.
The bright side is that China has opened the credit tap again, starting in the spring of 2018. We expect Chinese economic stabilisation by Q3 and a positive impact to Europe by Q4’19-Q1’20. Meanwhile, domestic measures to stimulate the economy need to be taken at the European level.
Monetary policy options
As it is so often the case, all eyes are on the European Central Bank. In a bid to win time and avoid a tightening squeeze hitting Eurozone banks, March saw the ECB announce a new round of TLTRO and a modification of forward guidance to extend its first rate hike into 2020. In our view, this is only a first step towards a more accommodative stance. As of today, discussions among ECB watchers are notably evolving around the idea of pushing the repo rate back to zero. The rationale behind this idea is that the benefit of negative rates is rather low; they are essentially a tax on banks that tends to further enfeeble the weakest banks. So far, the positive impact has been limited and has strongly depended on the structure of banks. The normalisation of the repo rate would be an easy move to reduce pressure on the banking sector if the risk of a tightening squeeze appears again.
Fiscal push in H2'19
Monetary policy options
As it is so often the case, all eyes are on the European Central Bank. In a bid to win time and avoid a tightening squeeze hitting Eurozone banks, March saw the ECB announce a new round of TLTRO and a modification of forward guidance to extend its first rate hike into 2020. In our view, this is only a first step towards a more accommodative stance. As of today, discussions among ECB watchers are notably evolving around the idea of pushing the repo rate back to zero. The rationale behind this idea is that the benefit of negative rates is rather low; they are essentially a tax on banks that tends to further enfeeble the weakest banks. So far, the positive impact has been limited and has strongly depended on the structure of banks. The normalisation of the repo rate would be an easy move to reduce pressure on the banking sector if the risk of a tightening squeeze appears again.
Fiscal push in H2'19
These measures alone will not be enough to stimulate growth. They may help to push the credit impulse higher but other measures to support demand are also required. As economic data will continue to disappoint in the coming months, we believe that a new consensus for looser fiscal policy will emerge in European countries in H2’19. An accumulation of negative German data could be the perfect trigger to set off expansionary fiscal policy in Europe. If fiscal expansion is equivalent to 1% of GDP in Germany, it could lead to an average increase in the output of other European countries by 0.15% after two years, with the strongest impact on small, open economies sharing a land border with Germany to be around 0.4% according to Beetsma, Giuliodori and Klaassen1. Though the spillover effect of fiscal expansion usually tends to be small, it is largely positive and, coupled with the ECB’s accommodative monetary policy and China’s credit impulse, could be the right answer to ongoing headwinds.
1: SEE BEETSMA, R., GIULIODORI, M. AND KLAASSEN, F., “TRADE SPILL-OVERS OF FISCAL POLICY IN THE EUROPEAN UNION: A PANEL ANALYSIS”, ECONOMIC POLICY, VOL . 21, ISSUE 48, 2006, PP . 640–687
1: SEE BEETSMA, R., GIULIODORI, M. AND KLAASSEN, F., “TRADE SPILL-OVERS OF FISCAL POLICY IN THE EUROPEAN UNION: A PANEL ANALYSIS”, ECONOMIC POLICY, VOL . 21, ISSUE 48, 2006, PP . 640–687
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