Econosights - The outlook for the Eurozone & ECB – political risks, manufacturing slump and negative interest rates

Introduction

The weakness in the Eurozone economy in the second half of 2018 was expected to be transitory, and a recovery in GDP growth evident in the second half of 2019. So far, there are few signs that this recovery occurring. Manufacturing business conditions (according to monthly purchasing manager indices) are very weak (akin to 2012 levels) and while the latest reading indicated that conditions may be bottoming, a further escalation in the US/China trade dispute may derail this stabilisation. Services business conditions are holding up, but are lower than a year ago. There are still plenty of downside risks to growth. Germany looks to be entering a recession, the Italian government has collapsed again and core inflation remains persistently low. In this Econosights we look at the outlook for the Eurozone.

The weakening in Eurozone growth over the past year

A spike in Italian political uncertainty in 2018 hit Eurozone growth. After it took months for a government to be formed after the election in March, the new government (a coalition between the far-right Northern League (NL) and the populist Five Star Movement (M5S)) was unstable because of divergent views within parties and also with the European Union (EU) in issues related to the budget and debt growth. This uncertainty hit investor sentiment and bond yields spiked.

A slowdown in German manufacturing activity has also been negative for the Eurozone. Manufacturing makes up a very significant 20% of Germany’s economy. Weakness in manufacturing activity is because of the US/China trade war which has disrupted global manufacturing supply chains and production, changes in car emission regulations in Germany and a slump in global car sales. The weakness in German manufacturing is evident in the hit to Eurozone net exports (exports minus imports) which had a sharp fall in 2018, dragging on GDP growth (see chart below).

As long as the trade dispute and its associated uncertainty continues, manufacturing activity will remain soft in Germany. German GDP fell in the June quarter and another fall is likely in the September quarter given the weakness in manufacturing, which means that Germany is in the middle of a recession.

Eurozone export growth relies significantly on Chinese growth. Chinese GDP growth has slowed over the past year and the trade dispute is hurting activity. Chinese import demand has weakened noticeably (see chart below) which has dragged down Eurozone net exports with it.

More political risks in Italy

The latest political development in Italy is a breakdown of the coalition government. While not entirely unexpected, it still means that Italy will need to form a new government, either through parties in the current parliament forming alliances and creating a new government or via a fresh election. The fractured nature of Italian parliament (with a large number of parties) means that it is uncertain what the new government will look like. If there is a new election, the most likely outcome is a NL dominated coalition. The NL is seen to be the most Euroskeptic party in Italy with its leader, Matteo Salvini, constantly making anti-EU remarks and clashing with EU rules. If he becomes the next Italian Prime Minister, it could lead to concerns from investors about an Italian exit from the EU. Although, the majority of Italians (68%) still support the Euro.

The NL’s desire to do more fiscal spending (mainly through tax cuts) may lift growth (which is desirable) but will face resistance from Euro leaders. Italian public debt is very high compared to its peers (like France, Germany and Spain) at 132% of GDP which is problematic if the government wants to increase spending. Although, private debt is less concerning, and Italy runs a current account surplus (of 2.5% of GDP) and the fall in Italian bond yields is helpful in limiting debt growth.

The other issue is that the budget needs to be drafted over the next few months. Elections will delay the budget process which is negative for economic confidence. There is also a risk that the scheduled hike in the value added tax in 2020 goes ahead.

Next steps for the ECB

There is clearly a need to stimulate growth in the Eurozone. But the problem is that monetary conditions set by the ECB are already very easy. The European Central Bank (ECB) sets three different interest rates:

• the main refinancing rate (at 0%): which is the rate at which banks borrow from the ECB longer than overnight
• the deposit rate (at -0.4%): which is the rate banks receive when making overnight deposits 
• the marginal lending facility (at 0.25%): which is the rate banks borrow at overnight
  

We expect more easing to be announced at the next ECB meeting (on 12th September). Quantitative easing is expected to be restarted (it ended in late 2018) with purchases of government and corporate bonds in the range of €30 50bn per month. The ECB has a 33% limit on the share of a country’s debt it can hold which will need a lift if asset purchases are restarted.

More interest rate cuts are also likely. Recently, the ECB used the deposit rate as its main policy tool. The negative deposit rate means that banks are being charged to put their cash reserves with the ECB. This is meant to encourage the banks to use their reserves normally deposited with the ECB for lending (and therefore to stimulate growth). Quantitative easing has led to banks holding large levels of reserves.

The deposit rate is likely to be cut by 0.10%, to -0.5% in September. This should give banks more incentive to increase lending. However, bank profitability could be hurt in the process. Banks do not tend to drop deposit rates for retail customers (negative interest rates have been passed on to some corporate borrowers) below 0% because it could lead to a loss of or a run on the banks if too many customers withdraw cash. The profit squeeze on banks from negative interest rates could be offset by a “tiered” deposit rate system, which would exempt some bank reserves from negative interest rates.

The chart below shows that when the negative deposit rate was introduced in the Eurozone 2014, it did lift consumer lending. As well, the unemployment rate has fallen from around 11% in 2014 to 7.6% currently. Corporate loans only really started rising over the past year. But even with that lift in lending activity, Eurozone growth still remains low at just over 1% and inflation well below the ECB’s target of 2%. Further cuts to interest rates will have limited benefits, which is also the signal sent from other countries who have done negative interest rates like Denmark, Switzerland and Japan. If anything, negative interest rates have hurt bank stocks in Japan and Europe over recent years.

The ECB could also cut borrowing rates (main refinancing rate and the marginal lending facility) further (and into negative) as another way of incentivising bank lending. The ECB also needs to ensure that its forward guidance provides investors with certainty that monetary policy will remain loose for a long time.

There is room for fiscal policy

The limits to further monetary easing in the Eurozone mean that fiscal policy needs to play a larger role. And there is appetite for fiscal spending. Current ECB President Draghi (he will be replaced by the head of the IMF Christine Lagarde in October) has specifically mentioned the need for fiscal policy (as have many other central banks!) to assist monetary policy. Fiscal spending should be around providing households with a boost to income or spending power, via tax cuts or welfare payments.

Recently, there has been talk of fiscal stimulus in Germany but this is not a certainty and there probably needs to be more clear signs of a German recession before policy makers respond. Fiscal spending in Germany makes sense as it is not constrained by debt, its budget surplus is 1.7% of GDP and public debt has now fallen to below the EU’s limit of 60% of GDP (although not all countries follow this!). Fiscal spending in Germany would also help Euro economies like Italy.

Implications for investors

Low Eurozone GDP growth is expected to continue for now with trade tensions and political risks weakening growth. ECB policy support, likely to be announced in September, will help stabilise GDP growth but a sharp reacceleration in Eurozone growth is unlikely in the environment of political and trade tensions. Further monetary easing should benefit European equities in the near-term but more cuts to the negative deposit rate may hurt Eurozone banks because of risks to profitability.