Changing of the Guard

Key points:

  • What the Street is Saying: the limits to ECB action Global cycle: Watching shoes dropping
  • ECB: What does continuity really mean?
  • Fed: Look who’s knocking at the door
  • What the Street is saying: Italian truce

Global cycle: watching shoes dropping

Although the G20 meeting brought a much-expected truce between China and the US, the lack of resolution on trade leaves us on the grumpy side, while the data flow continues to hesitate between mediocre and plain bad.

In the Euro area as an aggregate, the PMIs seem to have stabilised just slightly above the flotation line, but the cross-country details are worrying. Spain so far had defied gravity and maintained a very healthy growth rate. The sharp fall of the manufacturing PMI for June into contraction territory released this week may mark the end of the country’s impressive resilience (Exhibit 1), even if we remain cautious since specifically for Spain this indicator’s predictive power over actual industrial output is weak. Still, it seems that no major country member state now – with to some extent the exception of France – is escaping the general deterioration in industrial activity.

Exhibit 1 

Exhibit 2

Looking away from surveys, the picture is no better. The release of German factory orders this Friday brought another disappointment. The 2.2% mom drop in May (while the market was expecting a stabilisation) is taking the trend further down (-8.6% over one year). All sub-components are down, but the main drag continues to come from extra-Euro area demand. Germany is paying for its excessive reliance on emerging markets and a fairly small subset of highly cyclical products (investment goods and cars). 

What is crucial now is whether the woes of manufacturing are spreading to the economy at large. From that point of view, the negative surprise on the non-manufacturing ISM in the US released this week is not reassuring, even if the absolute level remains healthy. It’s difficult at this stage to understand if the convergence between the services and the manufacturing component of the ISM (Exhibit 2) should be explained in terms of contagion (bad global cycle affects US manufacturing which reduces its demand for domestic services) or if what is mainly at work here is the lagged impact of the US fiscal push fading. The US domestic picture, beyond the cracks in the housing market we’ve been highlighting in Macrocast, remains more than decent (the recent decline in consumer confidence started from historically elevated levels).

All this is manageable as long as the labour market is resilient. We take comfort in the fact that the employment components in US and Euro area surveys remain above their long-term average, although the softness in the creation of new temp jobs in Germany lately deserves to be monitored. The decent level of labour-related soft data in the US made us unwilling to over-react to the weak payroll number last month. The release of a stronger than expected number for June on Friday at 224k vindicated this view. The Fed does not need to “jump the gun” and cut in July already (our baseline is September), although given market’s expectations the FOMC might be tempted by a “hawkish cut” (ie cutting in July while making plain further cuts would be data dependent).

ECB: what does continuity really mean?

Given the market focus ahead of the European elections on the possibility the populists would force a drastic direction change for the EU, the nomination of Ursula von der Leyen at the presidency of the EU Commission is a striking outcome. Indeed, she reiterated her support for “the United States of Europe” in 2016 long after it stopped being fashionable, and as Minister of Defence in Germany promoted the idea of an “army of Europeans”.

The EU’s next steps remain uncertain though. For a long time – probably since Jacques Delors – the Commission has stopped acting as the key source of change in the EU. This role has shifted to the European Council. While preserving what the EU has achieved so far is highly consensual among the heads of government, they remain deeply divided on any road-map for the future of Europe, between those around Mark Rutte’s new Hanseatic League who believe more integration at this stage would merely stoke anti-European feelings, and those around Emmanuel Macron who want a common fiscal capability to protect the Euro area from external shocks.

This is why appointing someone such as Christine Lagarde to the ECB is so crucial. Since it is highly unlikely the EU or the Euro area will have reached a high enough level of consensus to respond in time to the current slowdown with a coordinated or centralised fiscal stimulus, the central bank is the last line of defence. Mario Draghi’s “whatever it takes” approach needs to be upheld. Christine Lagarde, repeatedly on the record supporting Quantitative Easing - brings precisely that: if the economic outlook sours further into the second half of the year and the Euro area’s “existential concerns” return, she will not hesitate long to argue for re-starting bond buying. She also has accumulated enough political capital in the core countries to sell such policy – which would force even closer sailing to the prohibition of monetary funding of governments.

But what about “steady state” monetary policy? The ECB under Mario Draghi was not only about responding to extreme events. He also laid out a very consistent and transparent “all-weather” monetary policy strategy. Quite simply, he brought to Frankfurt the New-Keynesian framework from the MIT.

We can describe it in a few sentences: even if is often elusive, the Philips Curve still exists, and inflation/deflation is ultimately the delayed product of the pressure from demand on supply, augmented by expectations on what should be the long-term pace of inflation, which itself depends on the central bank’s credibility in delivering on its inflation target. This is a much simpler approach than the pretty arcane monetarist strategy the ECB inherited from National Central Banks in 1999.

Draghi’s model entailed fairly predictable monetary policy decisions. If the economy is growing below trend, monetary policy must be eased until overcapacity is absorbed – especially if fiscal policy cannot contribute. If inflation expectations become de-anchored, monetary policy moves must be even more forceful than what the mere gyrations in the cycle would prescribe, to reassure on the central bank’s commitment to deliver on its target in the long run.

The Draghi model is still valid for the crucial next few months anyway. We don’t know yet if the ECB under Christine Lagarde (and the sweeping change in personnel at work through the board) will still follow those prescriptions. But in our view Mario Draghi will continue shaping the ECB’s decisions until his very last day in office. The key decisions on the next moves – whether or not to cut the deposit rate further and if so how to mitigate the impact for banks, whether or not to reactivate QE and how – will have to be made or at least telegraphed to the market before the end of this year. A change in the forward guidance to prepare such moves is likely in July already.

The real test is not now. Today’s need for further action is obvious, but we will need time to assess whether after Draghi unconventional policy becomes something reserved for the most extreme cases – with high risks of proper deflation or fragmentation of the Euro area – or should be seen as a fairly normal tool to make sure the central bank’s credibility on its 2% inflation target.

The team matters. Draghi was far from alone in shaping the ECB’s strategy. Peter Praet and Benoit Coeure brought key contributions. Judging by his first “big policy speech” in Helsinki on 2 July, Philip Lane, Praet’s successor as Chief Economist, seems comfortable with the “Draghi model” – the last section of his speech was actually a robust defence of the necessary commitment of the ECB to its inflation target – and is explicitly open to further accommodation, but he will naturally need time to build the tight rapport Praet had with investors and ECB observers. This makes the replacement of Benoit Coeuré at the end of the year very important in the shaping of “Lagarde’s ECB”.

Fed: Look who’s knocking at the door

While the European leaders were going through gruelling sessions to apportion the EU’s top jobs, Donald Trump decided to appoint to the Fed board Judy Shelton and Christopher Walker. Both candidates still need to go through the Senatorial scrutiny process, but the President has confirmed his willingness to change the Fed’s course with his choices of two doves.

While Judy Shelton’s conversion to super accommodative monetary policy is quite new – she was a staunch opponent of “currency debasement” at the time of the Great Recession and argued in favour of a zero-inflation target – Christopher Waller’s stance has been very consistent.

For those who still doubt the depth of the intellectual change currently at work at the Fed, we would advise to take a look at a piece he wrote with Aleksander Berentsen in 2016 in the Saint Louis Fed Review (“Price level targeting and stabilisation policy”). The paper is quite technical but the conclusion is straightforward: “if the central bank engages in price-level targeting, it can successfully stabilise short-term shocks to the economy and improve welfare”. Price-level targeting entails taking on board the accumulated undershooting of the Fed’s target for inflation since the Great Recession and allowing inflation to exceed 2% for as long as it takes to recoup the past deviation.

Walker – who stands the best chance of the two to be confirmed by the Senate – is not the only “price level targeter” at the Fed (his boss in Saint Louis Bullard, with whom he has been closely working, has been defending the idea) but he would further boost their influence.

Beyond the dovish offensive at the Fed, we are also focusing on the hurdles accumulating on monetary policy coordination. Judy Shelton is on the record stating accommodation by other central banks – thus potentially lifting the dollar exchange rate – jeopardises “monetary integrity” and could be akin to “currency manipulation”, echoing Donald Trump’s warnings after Draghi’s Sintra speech, which he reiterated this week.

So far, the major central banks have generally considered that monetary policy stimulus by their peers would be a net positive, the lift to global demand trumping the short-term impact on bilateral trade via the exchange rate (Greenspan for instance wanted a more dovish ECB to boost European demand and thus help rebalance the US current account). Irrespective of whether or not Judy Shelton makes it to the Fed, the “Zeitgeist” in Washington is moving in a direction where monetary accommodation outside the US is immediately seen as “currency war”.

We have already made the point in Macrocast: we think cutting the deposit rate further is not the most efficient use of the ECB’s depleted arsenal at this juncture. We understand why it is tempting when comparing with the complexities of QE, but the impact on the euro could be muted if the market considers that, in a race to the bottom, the Fed has much more leeway. Worse, it could tilt the balance in Washington DC towards implementing tariffs on EU products this autumn.

What the Street is Saying: the Italian truce

BAML’s Angeloni and Cordara looked hard at the “sovereign/banks nexus” in Italy (cross-asset view on 2 July). They recognize that the ECB-induced search for yields – in particular the plausibility of QE – is helping the Italian financial market out of immediate harm. The “truce” between Rome and Brussels on the 2019 budget is also helping (no hard decision will be made of excessive deficit procedure before the autumn). But they maintain their very cautious approach in general, given the country’s extremely weak nominal GDP growth which continues to erode debt sustainability.

Exhibit 3 

Exhibit 4

We share those views. The “ECB put” is helping exactly at the moment the economy is very close to relapsing into recession (the bad PMI reading in June was a surprise for Spain, for Italy unfortunately it has become systematic since the end of last summer). But the structural features of the economy are truly problematic. We are particularly concerned by the state of the labour market. The level of the employment ratio remains low comparatively to the rest of the Euro area, and the improvement these last few years has been relatively small (Exhibit 3). Conversely, Italy has now fully caught-up on the share of short-term contracts in total employment (Exhibit 4). This suggests that beyond an issue with the quantity of available labour supply, Italy now has a problem with the average quality of the jobs, which does not bode well for future productivity growth.

All data sourced by AXA IM as at 21 June 2019

This document is for informational purposes only and does not constitute investment research or financial analysis relating to transactions in financial instruments as per MIF Directive (2014/65/EU), nor does it constitute on the part of AXA Investment Managers or its affiliated companies an offer to buy or sell any investments, products or services, and should not be considered as solicitation or investment, legal or tax advice, a recommendation for an investment strategy or a personalized recommendation to buy or sell securities.

It has been established on the basis of data, projections, forecasts, anticipations and hypothesis which are subjective. Its analysis and conclusions are the expression of an opinion, based on available data at a specific date. All information in this document is established on data made public by official providers of economic and market statistics. AXA Investment Managers disclaims any and all liability relating to a decision based on or for reliance on this document. All exhibits included in this document, unless stated otherwise, are as of the publication date of this document. Furthermore, due to the subjective nature of these opinions and analysis, these data, projections, forecasts, anticipations, hypothesis, etc. are not necessary used or followed by AXA IM’s portfolio management teams or its affiliates, who may act based on their own opinions. Any reproduction of this information, in whole or in part is, unless otherwise authorised by AXA IM, prohibited.

This document has been edited by AXA INVESTMENT MANAGERS SA, a company incorporated under the laws of France, having its registered office located at Tour Majunga, 6 place de la Pyramide, 92800 Puteaux, registered with the Nanterre Trade and Companies Register under number 393 051 826. In other jurisdictions, this document is issued by AXA Investment Managers SA’s affiliates in those countries.

In the UK, this document is intended exclusively for professional investors, as defined in Annex II to the Markets in Financial Instruments Directive 2014/65/EU (“MiFID”). Circulation must be restricted accordingly. 

© AXA Investment Managers 2019. All rights reserved