La contagion s’installe

Key points:   

  • Bad winds from America: downturn crossing the borders of the services sector
  • Against policy pessimism: an investment-led fiscal push in Germany is needed – the alternatives are worse

Bad winds from America

In last week Macrocast, we highlighted in the US the dichotomy between the steep deterioration in the sectors exposed to global trade and the still decent dataflow coming from the bigger domestically-driven part of the economy. We mentioned our concern that gradually contagion would set in, if the high level of uncertainty on trade war in particular and on the political situation in general did not abate rapidly, with the labour market as the transmission channel. We thought we still had a few months of respite ahead of us, but last week’s dataflow suggests this may unfortunately be happening faster, even if some contradictions across indicators are blurring the picture.

The Institute of Supply Management (ISM)’s disappointing manufacturing index for September did not tell us anything really new, but the negative surprise on the non-manufacturing one came as a stark warning. We would single out the decline in the hiring intentions component of this index. At 50.4, down 2.7 points from last month, it is barely above the flotation line, reaching its lowest point since a one-off in February 2014. What we find particularly problematic is the fact that its current level is now slightly lower than at the trough of the short and mild “mini-downturn” of 2016 which is often hoped to be, for many analysts, the blue-print for the current slowdown (Exhibit 1).

US firms first responded to uncertainty by reining in their investment effort. In a second stage they may already be putting their hiring programs on hold as well. According to the historical relationship between hiring intentions in the ISM index and actual payroll data, job creation should have already stalled. However,  not all “hard data” is (yet) conforming to the message sent by the surveys

Exhibit 1 – Hiring intentions down, including in services

Exhibit 2 – Payrolls are already below the post 2009 trend

Payrolls are notoriously volatile, but at 136K in September job creation remained decent, and the upward  revision to the August print was reassuring. True, this is a notch below the trend established after the Great Recession. Since the peak in unemployment in 2010, job creation have been averaging 180k per month (Exhibit 2). But last week’s payroll is not providing a “smoking gun”.  The number of new jobs is still exceeding the increase in working age population (+85k per month on average over the last three years). The unemployment rate fell further, and this was duly saluted by the equity market after the release on Friday.

Still, other hard data are also pointing to an accumulation of headwinds in the US. We focused in our last Macrocast on the negative surprise on the latest batch of consumption data. Last week, our attention was caught by the “miss” on wages. The market consensus expectation stood at 3.2% for year-on-year wage growth in September. The actual number was significantly lower at 2.9%. This does not seem to be a one-off. Since a peak at 3.4% year-on-year in February 2019, an acceleration has been observed in only two months.  Over the last few weeks we had noticed in the Street literature a growing interest in the theme of the “return of inflation” in the US, on the back of the faster than expected print for core Consumer Price Index (CPI). It seems to us there is actually not that much pressure in the pipeline.

In this complex configuration, how should the Federal reserve behave? First, it should be forward looking, and surveys provide by construction more information about the future than hard data. Second, it should get its priorities right. If the inflation front is quiet, and it is, the central bank can do more to support the real economy. Third, the Federal Open Market Committee (FOMC) should consider what is the likeliest balance of risks ahead of us, and we think it continues to be tilted to the downside.

True, the causality of the relationship between the macro situation, asset prices and the political risks goes both ways. We have seen that at the end of last year: when the trade war started weighing heavily on US equity prices, Donald Trump dialled down the rhetoric. This could happen again and we have no doubt that any good news on the possibility of a “deal” between China and the US would lift animal spirits. But there is now another source of political risk – the impeachment  – which is not under control of the President.

Whatever the outcome of the impeachment is, we note that the process itself  may be detrimental to both Donald Trump and Joe Biden, who so far has been leading in the polls for the Democratic primary. This could play into the hands of other Democratic candidates whose policy platforms are far less moderate than Biden’s. All in all, this could fuel even more “wait-and-see”  attitude towards investment in corporate America.

On balance, we think the burden of proof is now falling heavily on the hawks at the FOMC as the “mid-cycle breather” narrative is getting weaker.  Cutting again this October is our baseline now.

Against policy pessimism

We were quite surprised by Mohammed El Erian’s latest op-ed in the Financial Times. As much as we share his scepticism on the power of monetary policy to make a difference at the current juncture, we do not think that policy pessimism should extend to the fiscal realm. Yes, a powerful, coordinated fiscal stimulus, spear-headed by Germany, would be difficult to organise. But that’s precisely why the debate needs to happen now. “Keeping the powder dry” on fiscal, as El Erian suggests, is problematic given the time it always takes for budgetary decisions to materialise, even in countries with simpler political structures than Germany, if only because the legislative procedure is slow and complex. The political will needs to emerge very quickly so that any actual fiscal package materialises in time.

When it comes to the capacity to “move the dial” on business conditions, there is (among others) one big difference between monetary policy and fiscal policy. The former creates a “potential” for additional spending by economic agents, who may or may not seize the opportunity, while the latter can lift aggregate expenditure directly. This is the main advantage of focusing on public investment. If the German government decides to boost its own capital expenditure , spending will happen. The chances of observing “Ricardian” behaviour, or “leaks” when it comes to spending ultimately under the control of the government are low, in contrast with tax cuts for instance which can be saved by their recipients.

It is obvious that so far the corporate sector in Germany has not responded to the European Central Bank’s extraordinary stimulus with the same gusto as in France, judging by their respective investment rate (Exhibit 3). We agree with El Erian that the main cause of the downturn in Germany is the deterioration of expected demand in the export-oriented sectors. This suggests that there is even less reason now to believe German firms would respond to the ECB’s additional stimulus. But what is also striking in Germany is the weakness in public investment (Exhibit 4).  True, its share of GDP has increased since the Great Recession, bucking the trend seen in the rest of Europe, but the difference with France remains massive. With gross public investment at 2% of GDP, it is far from obvious that the effort is big enough to merely offset the obsolescence of public capital. Irrespective of the current cyclical situation, there would be a need for more public investment anyway.

Exhibit 3 –German corporate investment has been very cautious lately

Exhibit 4 – Building up a public investment deficit in Germany

However, an issue with public investment is the time it takes to materialise, compared with “quick fixes” such as tax cuts or increases in social transfers. This is the case everywhere, but it specifically a problem in Germany given its federal structure and the need to coordinate decisions across Laender and municipalities. All the more reason to start thinking about it now.

We are fully aware of the major hurdles there. While disposing of the “black zero” which calls for a balanced budget irrespective of the circumstances is very likely for next year – so that “automatic stabilisers” would be allowed to play - the political bar for suspending the constitutional debt brake which limits the cyclically-adjusted deficit to 0.35% of GDP is high. But the alternatives are profoundly unappealing, at least politically.

Thinking about “helicopter money” solutions – with for instance the central bank injecting cash directly in consumers’ bank accounts, dubbed “people’s quantitative eeasing in the UK -  has become commonplace, and we note that at the last ECB press conference Mario Draghi did not dismiss the idea out of hand. He stated the Council had not discussed it “yet” and highlighted its complex legal and technical ramifications and the many different things “helicopter money” could mean – but also called it a “very interesting concept”. Our view is that at the moment, if it proved too difficult for Draghi to snatch from the Council the key decision on a more powerful QE (with the removal of the 33% limit) we don’t see how a consensus could form around an even more controversial option such as “helicopter money”.

But in a year from now, if the current approach to monetary policy proves inefficient and the fiscal stance in Berlin has not changed dramatically, the pressure on the ECB may become very high. Policy circles in Berlin should balance a “lesser evil” – allowing for a more pre-emptive fiscal policy at home – with the twin “bigger evils” of either a drift towards extreme solutions such as a “people’s QE”  or the return of existential threats to the monetary union, which we think would re-emerge if the weaker countries chose to re-start on their own expansionary fiscal policies, at a time when the ECB’s capacity to make them financially sustainable thanks to a truly credible form of “traditional” QE would be limited. 

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