Dans un monde post-brexit
- Many “accidents” weighed on GDP growth in late 2019 so that a natural rebound could have been expected in Q1 but soft data is likely to start reflecting the concerns around the coronavirus epidemic.
- The UK has finally left the European Union, but the terms of the debate have not changed. The EU’s temptation to seek a “neat” association agreement – even a very modest one - is exactly the kind of formal arrangements the British government will see as “Brexit in name only” it clearly wants to avoid.
- We look at a recent speech by European Central Bank board member Yves Mersch as a foray into the rationale of the hawks. It is quite straightforward: financial stability concerns should trigger a recalibration of the monetary policy stance, if need be at the cost of tweaking the measure of inflation. We think the market should notice. The pressure on Christine Lagarde is likely to rise, even if the ongoing deterioration in sentiment should support the status quo…for now.
The soft and hard data tango
Markets understandably focus at the moment on the Coronavirus epidemic. Before even getting into the very difficult business of trying to quantify the economic damage, we need to have a fairly precise idea of where the global cycle stood before the epidemic broke out. As often, the recent improvement in sentiment– more forward looking and more immediately reactive to the news-flow – triggered by the trade war truce has not necessarily been matched by fresh but backward-looking hard data. Symmetrically, from now on we could see some improvement in hard data reflecting the improvement of the news-flow at the end of last year colliding with a relapse in soft data as confidence starts being hit by concerns over the epidemic. This will make any cyclical assessment very difficult in the months ahead, possibly adding to a generic wait-and-see attitude, detrimental to corporate investment which has already been the weak spot in the world economy for two years now.
US Q4 GDP came out slightly above expectations at 2.1% annualised, and although this was still above potential (which we think stands at around 1.75%) some of the details were a bit disappointing, especially private consumption which grew by “only” 1.8%. This may be mere payback for the strong Q3 performance (+3.2%) but given the current mantra on many markets (“the economy will be saved by the US consumer”) this did not go down very well. Still, habitual readers of Macrocast won’t be surprised to know that for our part we focus on corporate investment, which fell for the third quarter in a row. It may well be that the good news on trade war came too late to rekindle animal spirits in the corporate sector, which would have allowed us to be more cheerful about Q1 (coronavirus permitting). Still, on top of the fallout from the epidemic, US GDP will be hit from Q1 2020 onward by Boeing’s travails (BAML for instance has already revised down its forecast for Q1 GDP from 1.7% to 1.2% explicitly on the back of the issues at the aircraft-maker).
Beyond those random shocks we continue to worry about the US economy settling on a lower growth trajectory, as intertwined low investment and low productivity gains gradually erode potential. One may find solace in the fact that within non-residential investment, spending on software continued its two-digit growth in Q4 (see Exhibit 1), but (i) capex in information processing hardware is falling, (ii) so far the impact of IT capex on productivity has been elusive, and (iii) given the rapid obsolescence of software, looking at gross investment in this type of capital can be misleading.
Exhibit 1 – Our main concern in the US: weak investment
In the Euro area, GDP growth came out below expectations in Q4, at +0.1%, down from an upwardly revised Q3 at 0.3%. Perhaps the biggest surprise – at least for us – was the decline in GDP in France which so far had remained very resilient. There are many reasons to treat this as a mere accident beyond the impact of the strikes. The contribution from inventories was particularly negative (see Exhibit 1). This is a very volatile series, which normally rapidly mean-reverses (the current string of three quarters in a row of negative contributions from inventories is quite rare).
Exhibit 2 – Inventories take French GDP down in Q4
All the other components of domestic demand provided a positive contribution to GDP, and net trade – often a drag to French growth – was balanced in Q4. Looking at soft data, the INSEE survey in manufacturing suggests no significant improvement, but from a decent absolute level (still slightly above the long term average, see Exhibit 3) while expected demand in the services has seemingly shrugged off the strikes (see Exhibit 4). So all in all, we are not overly worried by French Q4 data, even if some of the impact of the strikes will still be seen in hard numbers in Q1. Still, we are bracing ourselves for some deterioration in sentiment in the next batches of surveys in reaction to the epidemic.
Given the lack of details on the components, it is quite difficult to assess the 0.3% decline in Q4 GDP in Italy. To some extent, we were surprised last year by the resilience of the Italian economy given its structural features : a fairly large manufacturing sector dependent on exports and a very low potential GDP growth (estimated at 0.5% for 2019 by the European Commission) which offers very little capacity to avoid recessions even when faced with minor exogenous shocks (over the last 80 quarters, Italian GDP growth has been negative 30 times).
Exhibit 3 – French manufacturing has weakened but remains at decent absolute levels
Exhibit 4 – Sentiment in the French services sector shrugged off the strikes
German GDP number for Q4 will be released on February 14th only, but judging by the annual estimate for 2019 released by D-Statis and cross-checking with the GDP figure given by Eurostat for the Euro area as a whole it seems that Germany has escaped the contraction seen in France and Italy, with a quarterly growth of around 0.1-0.2%. This would be obviously re-assuring, even if over one year the performance would still be quite weak (c.0.5%, half of the growth observed in the Euro area as a whole).
The message on Germany from soft data available since the beginning of the year has been rather ambiguous, with a positive surprise on the manufacturing PMI and a negative one from IFO. This week the second estimate of the PMI for January could be quite interesting if some of the “late reports” start reflecting the first impact of the Coronavirus on confidence. Germany’s vulnerability to Eastern Asian demand is high, and significantly higher than in 2003 at the time of the SARS epidemic. Exports to China, Hong Kong, Taiwan and South Korea stand at 4% of German GDP today, against 1.5% in 2003 (2.7% and 0.8% respectively when looking at China alone). This is significantly more than for France for instance, for which exports to Eastern Asia stood at 2.2% of GDP in 2018.
True, the current crisis is for the time being hitting Chinese consumption more than any other component of GDP, which would reduce the second round effects onto the rest of the world. However, if the crisis is not rapidly under control, it is then more the production and investment activity of the country which will be hit, with deeper ramifications for global production chains. Besides, restriction to air traffic and travels by themselves could have a noticeable economic impact. Chinese tourists spent EUR 4bn in France in 2018. This is equivalent to 0.2% of GDP.
We probably already have to “write out” Q1 GDP in China, but the key issue is whether the crisis will linger into the rest of the year. Most sell-side research we have seen posit some measure of rebound by the spring, assuming a normalisation of travel restrictions. The idea there is that some of the missed consumption will catch up quickly. Some of this is likely to be los for good however, as income is starting to be hit (e.g. if some services businesses start laying off employees). In any case, if for now we retain as a working assumption of a mere replication of the SARS epidemic in terms of impact on Chinese GDP (slightly more than 1% of GDP) – which probably looks conservative at this stage – this would already be similar to our estimate of the effect of “trade war” last year (0.9%) on Chinese growth.
The Chinese authorities have already started to respond with targeted policy accommodation, and should the crisis linger more monetary and fiscal support would probably be brought. Still, we also need to consider the ramifications to other global risks though, in particular “trade war”. Indeed, doubling purchases of US products, as per the agreement reached with the White House, was in any case quite daunting for China. It will be even more difficult with slower economic activity, while a depreciation in the Renminbi could further complicate the relationship with America, which could be tempted to use China’s current weakness to impose even more concessions. Finally, the crisis is already souring further the relationship between Hong Kong and the mainland (a newly created union of healthcare workers in Hong Kong is calling for a strike to protest against the local government’s refusal to curtail more arrivals from the mainland).
The consensus among epidemiologists seems to be that there remain too many unknowns to produce reliable forecasts of the epidemic (e.g. is it certain asymptomatic carriers can transmit the disease). Still, for now the market is likely to focus on the fact that the slope of exponential trends fitted on the number of confirmed cases has not slowed down visibly yet in spite of the containment measures which continue to be enhanced (on February 2nd the Chinese authorities have imposed travel restrictions in Wenzhou, a 9 million people city 800 kilometres away from Wuhan). Even if this in itself is not necessarily surprising if the incubation period is long (the first major travel restrictions were implemented in Wuhan on January 23rd only), given the potential for the Coronavirus to re-shape profoundly the global macro outlook for 2020, the risk-off mood may persist until such slope changes.
Groundhog day in London
We were tempted to totally ignore “Brexit day” in this Macrocast – we confess having reached “peak Brexit saturation” a while ago – but we are afraid the issue will remain very relevant for European market in 2020. The same issues keep on coming back, in barely changed form.
The European Union would apparently prefer to deal with post-Brexit UK through a proper “Association Agreement”, following article 217 of the Treaty. This is more about process than content, at least initially: Association Agreements vary a lot in scope, but at least they offer a single framework to deal with some third countries (20 such agreements have already been signed). Crucially, an association agreement creates reciprocal rights and obligations between parties and institutions designed to implement and monitor the agreement. The latter is quite important for the EU which is very worried about the possibility for the UK to take advantage of a Free Trade Agreement (FTA) by diverging significantly on standards and will want a clear mechanism, built ex ante, to resolve future disputes. Incidentally, association agreements generally cannot be set up without the explicit endorsement of the 27 national parliaments, which would add to the pressure on the UK (snatching at the last minute a deal with the EU institutions which would be very uncomfortable to one or several member states would become much riskier). We suspect the Europeans also favour this solution because it is easily evolutive: a bare-bone FTA could be at first the only item under the association agreement, but gradually more and more issues could be covered (on security, data, etc…) so that gradually the UK could be nudged back to a close relationship with the EU – for instance if and once a non-Brexiteer Prime Minister succeeds Boris Johnson.
The political declaration which accompanies the withdrawal agreement mentioned the possibility that an association agreement could be the way forward, but this is not binding, and the latest noises from the British government suggest that even a modest agreement of this nature would still be seen as too much a compromise on national sovereignty. For now, the UK seems comfortable with pursuing a very, very low quality deal, even below the “Canadian precedent”.
So, as often with Brexit, we are stuck, as we keep on coming back to disagreements on first principles. This is actually quite close to the situation which prevailed at the very beginning of Mrs May’s Premiership. Gradually, she came to a more conciliatory approach. Many observers probably still hope Boris Johnson will follow the same arc. We would love to believe this. We fear significant economic damage may have to come to the UK before this happens, if it happens.
On Mersch: How the ECB hawks think
We have been suspecting for a while that the ECB’s strategy review would not manage to keep the debates “in-house”. Benoit Coeure’s “farewell speech” which we commented at length a few weeks ago could be seen as the opening salvo from the doves – although it also contained a few nuggets for central bankers of a more conservative inclination. In turn, in his speech last week board member Yves Mersch set the hawks’ stall. The key sentences came as early as the second paragraph: “the prolonged period of substantial accommodation and the unconventional nature of our measures call for vigilance on the efficacy of the policy measures and might affect the strategic calibration and the appropriateness of the monetary policy stance (…)This vigilance is particularly warranted in the light of some signs that monetary policy is encouraging increased risk-taking and contributing to elevated asset price inflation and income inequality.”
This is bold because here Mersch draws a direct link between financial stability and the calibration of the policy stance. The generally dominant view is that while financial stability is almost mechanically affected by monetary policy decisions (lower rates, all else kept equal, raise the appetite for risk), this does not mean that monetary policy decisions should be unduly influenced by financial stability considerations. Indeed, the monetary policy stance, based on a few instruments, can only target the economy as a whole. Financial stability concerns itself with sectoral or regional responses to the policy stance, e.g. house prices, usually only in some segments of the monetary zone (house prices have increased a lot in France, substantially in Germany but they fell in Italy). Dealing with these localised issues is normally the remit of macro-prudential policies, through banking supervision or taxation.
However, Yves Mersch’s argument is twofold. First, time substitution. His main point is that by letting bubbles develop, accommodative monetary policy for too long would ultimately create the situation which will trigger a very significant economic downturn (through a brutal correction in asset prices generating systemic issues for the financial system). He does not make the point fully explicit, but we think his implicit view is that in terms of total welfare loss over the long term, it is better to accept slightly less growth today to curb asset prices rather than take the risk of a massive GDP decline down the road. Second, the limits of macro-prudential policies. His point here is that since a growing share of lending is no longer done by the banks – which are the main vector of macro-prudential action – the capacity of the traditional prudential tools to address bubbles has diminished, so that monetary policy needs to take this extra burden. Finally, he closes the loop by arguing in favour of better taking into account house prices in the measure of inflation favoured by the ECB, which would mechanically help instil in the calibration of the monetary stance some regard to asset prices.
We have already expressed at length in Macrocast what we think of tweaking the measure of inflation followed by the ECB. In addition, introducing financial stability in the ECB’s reaction function would de facto create a policy asymmetry: indeed, while it is easy to see how a fast rise in asset prices would lead to a tighter monetary policy at any given level of consumer price inflation, the opposite would be unlikely (would the ECB cut faster when asset prices are falling if consumer prices are close to target?). We are quite concerned with the repercussions on the euro’s exchange rate if the market starts pricing in a new “conservative bias” at the ECB now that Mario Draghi is gone. Still, we would take this critique of the “Draghi’s monetary policy handbook” seriously. A large number of Governing Council members are obviously quizzical about the appropriateness of the current stance. It would not take much in the dataflow, in our view, for the temptation to “recalibrate” to become irresistible.
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