Macrocast - In need of new coordinates
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Besoin d'un nouveau cap

  • Italy is stepping up its containment effort but the country is not in the best position in Europe to deal with a large-scale epidemic. Beyond the healthcare issues, some features of the Italian economy can make the downturn particularly steep.
  • The G7 communique failed to revive markets. We think much more will need to be done on the fiscal side in the US as well.
  • The ECB will provide some easing on Thursday, but we are still not convinced they will cut the deposit rate.
  • The credit market had been mostly spared until late last week. The further drop in oil prices won’t help. Central banks need to pay attention.

Covid-19: Italy is facing an uphill struggle

With 6,387 cases reported to the WHO as we write these lines on Sunday, the infection rate (cases/total population) in Italy is almost twice as large as in China (0.1 per 1,000 against 0.058), assuming of course that the counting technique is comparable across the two countries. Unsurprisingly, the speed of the epidemic is now triggering a more aggressive response of the Italian authorities, with the entirety of Lombardy and 14 provinces in other Northern regions now in lockdown until at least April 3rd. Italy is going the “Chinese way” on trying to contain the epidemic, and this will undoubtedly add to the already significant economic shock. Our revised forecast for Italy in 2020 of a decline in GDP of 0.6% already looks very optimistic.

Italy is specifically vulnerable to a large scale epidemic. The number of physicians is relatively high (at 3.95 per 1,000 persons Italy compares favourably to France at 3.14 and is not far from the German level of 4.19) but the hospital system lacks resources. Hospital staff stands at 10 per 1,000, against 16 in France and 19 in Germany. The number of ‘acute hospital beds” (by opposition to “long term care beds”) is also on the low side at 2.6 per 1,000, against 3.1 in France and 6.0 in Germany. In addition, the Italian healthcare system needs to deal with an already aged population: 6.8% of the Italian population is over 80, against 5.9% in France and 6.0% in Germany. Timing is also problematic. As the first Western European country massively hit by covid-19, Italy is facing pressure on its healthcare system before the usual seasonal peak in hospitalisation recedes.

The organisational issues Italy is facing are thus quite daunting, and this will require significant public spending. The Italian government has just doubled its fiscal package dedicated to the epidemic to EUR 7.5bn. This is still relatively small (less than 0.5% of GDP), but this will add to the rise in the public deficit stemming from the “automatic stabilisers”, i.e. the decline in tax receipts and rise in expenditure triggered by the economic slowdown. The European Commission was expecting a deficit of 2.3% with GDP growing by 0.4%. The sensitivity of the overall deficit to growth is close to 0.5 ( a 1% decline in GDP raises the deficit by about 0.5% of GDP). Our own growth baseline for 2020, added to the “epidemic package”, would already put the total deficit to 3.3%. And unfortunately we are afraid the risk to growth lies squarely to the downside.

Indeed, the Italian economy’s specific features make it quite vulnerable to a shock of this nature, with the probability of a supply-side crisis to morph into a demand-side downturn higher than in other European countries. Nearly 17% of the Italian workforce are self-employed (see Exhibit 1), a very high level relative to other G7 countries. In times of downturn self-employed workers usually do not “lose their job” or at least not quickly, but they experiment an immediate drop in income, which cannot be easily covered by social transfers, while wage-earners can count at least temporarily on a fixed income (businesses absorb the short term shock in their profits). In addition, business resilience is probably a function of size, and unfortunately two third of Italian workers are employed in firms with less than 10 employees (see Exhibit 2). Permanent losses (i.e. cuts to income that won’t be recouped) will be massive, even after taking into account the support measures offered by the Italian government (e.g. delays in tax payments).

The Europeans have already agreed to “waive” the budget discipline rules for Italy – it would difficult to argue anyway that the current situation does not constitute one of the “unusual evens outside the controle of government”” escape clauses in the Stability and Growth Pact. The letter from Valdi Dombrovksis (EU Commission Vice-President) and Paolo Gentiloni (Commissioner for the economy)  to the Italian Prime Minister was very clear about this but beyond the institutional machinery, the underlying economic and fiscal trajectory of Italy is going to be impaired for long. Support will be needed in the medium-term. As we argued last week, beyond the short term policy reaction, the policy-mix will be impacted well beyond the end of the epidemic. We want to read Dombrovskis and Gentiloni’s letter in that light, in particular the following sentence: “ when assessing the 2020 stability programme, the Commission will be mindful of Member States’ need to implement urgent measures to safeguard the wellbeing of citizens and mitigate the negative effects on economic growth of the Coronavirus outbreak”. Given the multi-year nature of stability programmes, this may open the door to a reprofiling of the trajectory.

Decisions, decisions….

The G7 communique failed to revive the markets last week. “Coordination” can take many forms in economic policy, but in the current circumstances one would spontaneously think in terms of (i) international coordination – the principle should be that the countries with the widest policy space should deliver the biggest stimulus – combined with (ii) cooperation between the branches of policy, the effort between fiscal and monetary apportioned according to the remaining capacity for action and the speed of delivery.

Immediately after the release of the communique the Fed delivered a forceful 50 basis points cut. This satisfies the two conditions we highlighted above. Indeed, the Fed has much more space than the European Central Bank and given the already high level of the US fiscal deficit (4.7% of GDP in 2020) and the usual lags in the capacity of fiscal policy to support activity, it probably made sense to start with monetary policy.

Yet, in the current configuration, there is some specific need for fiscal action anyway. Indeed, beyond providing a cyclical boost, in first intention dealing with the epidemic requires in any case a public spending effort. For now, the number of cases in the US remains comparatively small but it could be due to (so far) a low availability of tests. The structure of the US healthcare system does not make it very well equipped to deal with the beginning of an epidemic. Using the OECD data again we find that the supply of “acute hospital beds”  is even lower in the US than in Italy at 2.4 per 1,000 persons. Beds in publicly-owned hospitals are particularly scarce (0.6 per 1,000 people), about five times less than the European average. In addition, the lack of comprehensive indemnification of “sick days” in forty US states could incentivise infected people to continue to come to work and thus contribute to a further propagation of the virus. From this point of view the USD 8bn additional spending agreed between the White House and the House of Representatives last week looks small. It is equivalent to 0.04% of the US GDP, while the cost of a run of the mill seasonal flu epidemic stands at around 0.1 to 0.2% of GDP.

So it is likely more will be needed on the US fiscal side, which the current political configuration makes quite difficult to count on. Of course at some point national interest will prevail, but Democrats and Republicans are so far apart – in an electoral year – that agreeing on the details of a proper fiscal push will be difficult. In the meantime, the Fed is likely to be “the only game in town”, and this may explain why the market “saw through” the cut and immediately pushed for more. We concur and we expect another 50 bps of easing in two instalments (at the regular March meeting and then in April).

This may be construed as over-reacting but the Fed may be prisoner of its own framework. Members of the FOMC have been increasingly commenting directly on the shape of the yield curve, and it remains significantly inverted even after the cuts. The equity market continues to correct, with consequently the possibility of negative wealth effects impairing consumption. We know it is a mechanism which the Fed is quite sensitive to. 

Lagarde and the ECB’s arsenal

The ECB’s Governing Council is meeting this Thursday and we would be surprised if no monetary policy easing at all is announced. We maintain the view we expressed last week: while the response to the current crisis should essentially be fiscal, we think monetary policy still has a role to play. Our focus here is on corporate cash-flow and the high probability that some businesses will be facing existential threats in the months ahead. This is why we consider that gearing up the corporate bond purchasing programme would be welcome, magnifying the shift towards private assets which has already been observed since the central bank re-started its purchases last year. The strategists from BAML believe that the ECB could raise its total purchases quantum to EUR 30bn/month for 6 months if they chose to skew it further to corporate bonds and opted for the maximum divergence from the capital key on sovereign bonds which has been observed so far. While we think supporting the corporate bond market is by now consensual at the ECB so a further shift towards this asset class is very likely, the central bank may be observing market conditions early in the week before embarking on an outright increase in the quantum of purchases.

However, given the Euro area’s dependence on intermediated lending, supporting the corporate bond market will not be enough. It is highly unlikely that such action would percolate down to SMEs. We would thus expect from the central bank some tweaking of the TLTROs to incentivise banks to maintain their credit lines to small businesses. Carving out a specific “pocket” of funding backed by new loans to SMEs at more generous conditions would make sense.

The thorny issue lies in the deposit rate. The market is fully pricing a 10 bps cut now, and given the appreciation in the euro last week not “giving in” to market pressure could trigger another dollop of competitiveness loss. We note that Philip Lane, the central bank’s chief economist, insisted two weeks ago that the ECB had not yet reached the point at which cutting policy rates would be counterproductive. In principle, since the central bank is very likely to revise down its forecasts for growth and inflation on Thursday, such a move would fit the current forward guidance, allowing for rates to go “lower” if the outlook were to deteriorate. Still, a move on the deposit rate – a “blunt” instrument – would not qualify for the “targeted” action the ECB pointed to in its latest communication.

Perhaps more importantly, on substance, we fail to see what another 10 bps cut to the deposit rate would do to help the Euro area economy at the current juncture. It won’t help the banks at a time when they are facing additional pressure. Beyond the rise in non-performing loans which will naturally result from the incoming downturn, European banks have not yet completed their programme of issuance of “Minimum Required Eligible Liabilities” (MREL) – a part of the regulatory effort to force credit institutions to build bigger buffers – and may have to pay heightened funding premia for this in the new market environment. The exchange rate argument would be stronger if we thought the ECB could win a “cutting war” with the Fed, but given the remaining interest differential and the fact that a -1% we think even the most enthusiastic proponents of the negative rates would consider a limit has been hit (because hoarding physical cash would become a financially attractive proposition), the outcome of such a “war” is quite predictable.

While we acknowledge there is a significant risk the central bank will feel compelled to “cut anyhow” on Thursday, we still don’t want to make it our baseline. In any case if the ECB moves we think the quantum would be small (10 bps). This matters for the bond market. Since the central bank has brought the deposit rate in negative territory, the 10 year Bund yield has never fallen below the level of the expected deposit rate (see Exhibit 3). This is consistent with the view that the “trough” in core yield is close.

Credit to be “closely monitored”

Until the end of last week, the spread widening on the credit market had remained quite subdued relative to previous episodes of stress (see Exhibit 4). On Friday though investors started to react to the possibility that the current downturn could elicit a rise in default rates. This asset class is going to be hit through another channel. Oil prices are now falling very quickly following the decision by Saudi Arabia to reduce its own wholesale prices (as we write these lines the contract for May has fallen to only marginally above USD 30/bbl). This seems to be reaction to the failure of OPEC to coordinate a reduction in supply to shore up prices against a background of downward revision in demand. The Saudis may have chosen volumes over prices and could be trying to win market shares. This may have some consequence on the credit market: energy companies account for 11% of the US high yield market.

We note that the Fed – which contrary to the ECB does not dabble in corporate bonds – may be thinking about tweaking its own arsenal.  Boston Fed President Eric Rosengren on Friday argued that the US central bank may have to “buy a broader array of assets”.  He justified it by the fact that with the interest rate on risk-free assets falling so low the Fed would have to focus on other instruments, but we think this justification may come in handy if the credit market needs support. Note though that this would not be straightforward for the Fed (they would need the agreement of Congress to engage on this front).