Exit the Draghi
Mario Draghi expanded and then exhausted the monetary policy tool kit during his eight years as ECB president. The high point was his statement at the peak of the euro-crisis in mid-2012 that the ECB “is ready to do whatever it takes to preserve the euro, and believe me, it will be enough." It calmed markets and demonstrated the power of the central bank as the lender of last resort.
His last policy action in September 2019, however, illustrated the limits of central bank policy. Draghi cut the interest rate on overnight reserves by 10 basis points to -0.50% and restarted quantitative easing (QE) at a rate of €20 billion per month. The ECB ended its previous QE program last December after cumulative purchases of €2.9 trillion, mostly in government bonds.
Pushing the ECB’s policy rate further negative and re-starting QE are unlikely to provide much economic stimulus, however. The latest addition to central banking jargon is the “reversal rate”. This is the point where negative central bank interest rates start to depress rather than support economic activity. It operates mostly through bank profit margins, where the spread between the cost of funding (mainly bank deposits) and the average lending rate is compressed. This can discourage banks from lending.
We’re not sure where the reversal rate lies, but -0.5% can’t be far from it. The other monetary policy transmission channels, QE and currency depreciation, are also near their limits. Ten-year German bund yields at -0.45% have limited scope to decline further and the euro, at 1.1 to the USD, is already very undervalued.
Fortunately, there is evidence that eurozone credit conditions were improving before the ECB’s latest move. Monthly lending by banks to households and non-financial corporations has been increasing since February and is now close to €40 billion per month. This is the highest pace of monthly bank lending since the 2008 financial crisis.
The Bank of Italy’s monthly Eurocoin indicator, which tracks underlying gross domestic product (GDP) growth in the eurozone, tentatively suggests that the growth slowdown since early 2018 may be starting to bottom.
The economic weakness has been focused in manufacturing, with Germany hit hardest. Automobile production is yet to recover from last year’s declines following the European Union’s new emissions testing regime. Car exports have been hurt by the global trade war. There is some evidence that global car demand is now running above production levels, opening the possibility of a recovery in the fourth quarter.
One of the risks we were concerned about last quarter has eased. Italy’s political crisis has reached at least a temporary resolution with the left-wing Five-Star movement forming a new coalition government with the center-left Democratic Party. The departure from government of the right-wing populist Lega party, led by the combative Matteo Salvini, has eased fears of a stand-off with the European Commission over budget rules. Italian bond yields have declined significantly as a result. The new government may not be long-lived, but it has pushed the risk of new elections well into 2020.
There is less clarity on the other two risks for Europe—the trade war and Brexit. Tensions between the U.S. and China appear to be easing as President Trump starts to focus on his 2020 re-election. Europe’s export dependence made it a casualty of the trade tensions and it will benefit from a truce. The U.S. decision on European car tariffs will likely be delayed beyond November 14 if China/U.S. trade talks are ongoing.
The Brexit end-game is difficult to forecast. A chaotic no-deal exit seems the least likely outcome, but nothing is certain ahead of the October 31 deadline.
- Business cycle: The cycle should marginally improve over the coming months as car production recovers, although this is taking longer than expected. Exports to emerging markets are equal to nearly 10% of eurozone GDP, which means a further escalation in the trade conflict is a significant risk. Equally, Europe will get a boost from a trade thaw and should be one of the main beneficiaries of significant China policy stimulus.
- Valuation: Eurozone equities are close to fair value on our calculations, compared to U.S. equities, which are expensive. Core government bonds are long-term expensive, including 10-year German Bund yields at -0.45% in mid-September, and we see limited scope to fall further.
- Sentiment: Contrarian sentiment signals are broadly neutral as of mid-September. There are no signs that equities are either overbought or oversold. Price momentum in eurozone equities is slightly positive.