Europe’s destiny is in its own hands - Macro Thoughts April 7
Having first mentioned concern about ‘a mystery SARS virus outbreak’ on January 5 and warned that ‘between 2002 and 2003 a similar virus spread to 37 countries’, we continued, throughout February, to highlight how the potential risks and global implications were being underestimated and not taken seriously enough. Whilst Chinese equity markets fell 10% in January, in the US, equity markets were still hitting new highs, as per the usual annual herd migration, stampeding to fill portfolios. China seems to have been less than transparent in revealing the full impact of the virus in Wuhan, leading to complacency and unpreparedness, both globally and across China itself; it wasn’t until mid-February that Chen Wei, China’s top military biological weapon expert, who developed their medical spray during the SARS outbreak in 2003, was moved to Wuhan.
It would take the Italian government’s lockdown decision on March 9 before the World Health Organisation announced COVID-19 as a pandemic on March 11, with Spain following Italy in to lockdown on March 15. Despite China’s low official figures for those affected by COVID-19, even now, non-essential crops are still prevented from being attended, under restrictions on farmers.
Even now there seems to be an underestimation of the impact – it only took days before Trump turned from optimism, saying there would be a return to normality by Easter (this weekend), to saying there could be 100k deaths and 1 million cases in the US.
Trillions of Dollars have been released globally to create some stability and prevent companies going bankrupt, but this won’t prevent global growth being negative, and still policy mistakes are being made and then swiftly reversed - that’s if an agreement on policy can be made at all – whilst pressure for exit strategies to be formulated looks premature, as lockdowns look certain to be extended.
The global economy has never fully recovered from the financial crisis of a decade ago, and the COVID-19 crisis will take even longer to recover from. If anyone understands the condition of the global supply chain, and what demands are being made for the delivery of medical equipment, it is Amazon, therefore while the potential postponement of Prime Day might be understandable, the fact that the event takes place in mid-July perhaps gives a sense of realism of how long the impact of the virus might last and how broken global trade is.
The average of global central bank rates has now fallen to 4.75%, almost 1% lower than it was at the start of the year, with many cutting more than once during the same month. Kazakhstan has reversed its rate hike, and Denmark may need to follow. Israel's central bank has cut for the first time in five years, and the Eastern Caribbean Central Bank (ECCB) lowered its benchmark discount rate for the first time in 17 years. Japan has announced a JPY 108 trillion stimulus package – nearly 20% of GDP.
China itself is relaxing policies with an eye on maintaining policy to deal with shadow banking and maintain Xi’s ‘Four Comprehensives’ initially announced in 2017.
In its most recent announcement, the PBOC said it will cut the targeted RRR by 0.5% on April 15 and again a month later, but that they were only targeting smaller banks, so it will release Yuan 100bn less liquidity than their previous cut (Yuan 400bn). They will also lower the interest rate paid for excess reserves (IOER) from 0.72% to 0.35%; accordingly, some small banks will see the reserve ratio fall to only 6%.
After the crisis, Europe will never be the same again
Inexperienced European leadership at the EU and ECB has caused more problems than they have solved. They now have to find some credibility, while the risks of a break up are greater now than Brexit might have posed. At the end of February, the ECB’s Lagarde said there was no obvious need for a stimulus, yet the Fed was cutting, the G7 was arranging conference calls and the OECD was cutting its global growth forecast, again.
Since the financial crisis, Macro Thoughts has emphasised how Europe has been the bellwether of the global economy. Now, the inexperience of its leadership has been found out, creating greater difficulty for governments who have been asked to provide fiscal assistance to monetary policies, yet it has been the ECB that has been responsible for increasing the cost of funding any stimulus, creating greater problems for national leaders.
A chain is only as strong as its weakest link and, rather unfortunately, it has been Italy that has had the worst experience of COVID-19, and so far the EU and ECB have only given limited support, leaving Italy’s coalition to throw away budget restrictions.
Italy needs a decision, either help through a Euro Bond or some other kind of funding, yet so far Europe has failed to find any consensus on how to deal with the crisis, at a time when the EU should be taking firm control and justifying its raison d’être.
Without waiting on the EU or ECB, Italy has announced their latest stimulus, worth Eur400bn, bringing its total injection to Eur750bn, 50% of its GDP, yet even understanding what its growth rate is under normal conditions is difficult, as GDP had effectively been experiencing recessionary conditions throughout 2019; Q4 2019 GDP was -0.3% qoq and only 0.1% yoy.
Half of the Eur400bn will go to support exports and half for domestic companies through cash and lending, aimed at preventing bankruptcies and in part aimed at post-crisis recovery, although 2020 GDP is still expected to contract -8%.
New ECB Governor Lagarde (by now, famously) said that the ECB was ‘not here to close spreads’, thereby managing to blow away Eur120bn, as she increased her original Eur60bn of stimulus that was meant to calm markets, having quoted her new German ECB member Schnabel, who only took her place in January, and had previously said she would not support any further bond purchases.
Boom! Italian 10 year bond yields had started the year at around 1.45% and had fallen to 0.86% within a month. By the end of February, they had risen to 1.14%, higher but still lower than in December. Lagarde’s comment would push yields to 2.45%, 1% higher than they had started the year; they have since fallen, but are still higher than 1.5%, increasing the cost of funding fiscal packages, unnecessarily.
Lagarde was hastily made to back track on her comment, and little has been heard from Schnabel since, but the damage has been done, and all the support and confidence in peripheral bonds that Draghi had managed to build since the introduction of OMT in 2012 has been lost, at the worst moment.
Policy failure has been shown in the take up by European banks of $112bn of swap lines, freed up by the Federal Reserve, which highlights how ridiculous the ECB has been in its reliance on bank stress testing since the financial crisis.
We had warned at the time of her appointment at the ECB that Lagarde was more hawkish than many were forecasting, and that this wasn’t peripheral bond friendly. She was in charge of the IMF that forced Greece into austerity, while failing to produce any early debt restructuring (initially broached by Finance Minister Varoufakis in 2015, which didn’t come about until four years later, at the cost of millions in interest payments) and, even in her first QE announcement, Greece wasn’t included in bond purchases; being omitted from the ECB’s QE ‘bucket’ has meant that Greek credit is not Investment Grade. As if forgotten, it took a call from the Greek PM to Largade for Greece to be included in the latest QE increase.
After the usual in fighting between EU leaders, all with their own interests to defend, Europe is being forced to come up with an agreement, and a big one, without ties and counter policies.
Although EU diplomat Borrell said ‘It is the same as during the great crisis in the euro…we must continue to look for more solidarity’, Europe has stumbled from one crisis to another. Despite obvious problems in the US as the financial crisis and subprime developed, the ECB raised rates early that summer, and would largely allow other central banks to loosen policy, before comments from the Fed forced them to act more swiftly, and it took Draghi’s initiative before peripheral yields stabilised in 2012.
Germany has given greater emphasis to trade and productivity with China than it has with the rest of Europe, but was happy to sell Porsches in the thousands, on credit, to Greece as it joined the EU in 2004. This has to change, for Europe to survive.
The EU’s Multiannual Financial Framework (MFF) budget summit ended at the end of February without an agreement, with the four largest (frugal four) contributors looking for savings, while the rest of Europe are asking for more from the pot, or to at least retain the status quo, and there are still disputes. The UK leaving the EU has left a Eur75bn hole in the long-term budget (2021 to 2027) that needs to be agreed by the end of the year.
Eur500bn should be the minimum provided by the Commission and more will be needed. Those economies hardest hit need funding help, immediately. Italy has been forced to move now, but when the lockdown ends, there will be a need for leaders to follow up with policies that will unite the continent, not divide it.
New leadership in the EU appears to be in favour of Euro bonds. European Commission President Ursula von der Leyen has said ‘several instruments’, including bonds, are being considered and are discussed in the Euro Group, and may even have been considered before the virus, in tackling the EU’s problems in funding their long term budget.
It seems, however, that the EU will go down the same route as before, by using the ESM (European Stability Mechanism) Eurozone bailout credit lines. Two types of credit line are available; PCCL for economies that are stable but under market stress, and the ECCL (Enhanced Conditions Credit Line) for those who can't meet those stricter criteria for a PCCL, where conditions will be closer to the restrictions used for Greece. Spain’s Sanchez has said he wants more than Eur50bn of loans and credit and that the plan to use the ESM won’t be enough.
Merkel has always been against the introduction of a Euro Bond, though we believe this would have created greater unity. Macro Thoughts, March 25: ‘We have argued since the 2011 European crisis that a form of EuroBond should have been introduced (which would have helped Greek interest payments) and, now, German Chancellor Merkel has said she wouldn't rule out joint EU debt issuance, in an apparent softening of German opposition that will help transform the finances of the 27-nation bloc’.
Hopefully, at today’s press conference (due 20.00CET today), a package of that matching Japan’s will be announced.
This and all Macro Thoughts reports, along with performance track record for investment & hedging strategies across asset classes, can be seen on the website www.macrothoughts.co.uk
Keith Grindlay - Macro Thoughts Ltd.
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