Macrocast: Iberian limits

Key points:

  • ECB: Unsurprisngly in her first speech as ECB President Christine Lagarde called on more support from fiscal policy, while Philip Lane seems to lean against opening a debate on ending negative policy rates.
  • Iberian limits. Both Spain and Portugal are politically dominated by centre-left/radical left alliances. We look at how wide their macro room for manoeuvre is.
  •  UK elections: the race is polarizing and the Tories’ lead is solidifying. Their manifesto stays well clear of promising a “supply-side revolution”

ECB: With a (lot of) help from my friends

We suggested earlier in Macrocast that Christine Lagarde would engage in some “institutional judo”, i.e. playing up the weaknesses of the European Central Bank – the depletion of its monetary policy arsenal – to obtain from the national governments a decisive shift on fiscal policy. She did not waste time and this has been the line she adopted in her first policy speech last Friday. Out of the 2288 words of her speech, the paragraphs dedicated to monetary policy amounted to only 86 words, including the key sentence that it “could achieve its goal faster and with fewer side effects if other policies were supporting growth alongside it”. Fiscal policy was the first item on that list.

It is not necessarily surprising that she chose not to elaborate on monetary policy proper, since she will hold her first post-Governing Council meeting press conference on December 12th. Given the new insistence from the council on collegiality, in contrast with Mario Draghi’s fairly solitary  management style, it probably makes sense for her not to elaborate on monetary policy proper before the first formal meeting of the ECB’s decision-making body. We do not expect fireworks on December 12th anyway. The September package has a longish shelf-life, and since Lagarde has re-iterated the launch of a “strategic review”, it is likely  any significant shift in the message will have to wait the completion of this process.

The wait-and-see attitude was also quite obvious in Philip Lane’s comments last week. The convergence in communication between the Fed and the ECB is becoming ever-more striking. In our previous Macrocast we noted that Jay Powell had borrowed from Draghi’s words to state that fiscal policy would have to be involved in dealing with any downturn. This time the ECB’s chief economist used almost the same line as Powell to describe the central bank’s current stance (“Our monetary policy is in good shape” echoing Powell’s point on the Fed being “in a good place” after the three cuts). He sided with Lagarde on the limits of what monetary policy can do, arguing that in the effort to spur investment, “the role of the ECB should not be exaggerated".

To some extent, the recent data-flow is playing in the hands of the ECB arguing the current level of accommodation is right. The November flash manufacturing PMI index came out 0.2 points above expectations and improved 0.7 points relative to October. The depressed absolute level (46.6) remains consistent with a nasty contraction in activity in the sector, in particular in Germany, but the latest batch suggests the industrial sector may have bottomed out. The services sector continued its slide though, at 51.5, noticeably below expectations and the previous month level, but those who like their glasses half-full will probably argue that services usually follow manufacturing with a lag. There is more inertia in the services which are less exposed to the global cycle and by construction are not affected by steep inventory movements. Encouragingly, the forward-looking, “new business” component of the index edged up slightly.

Still, we were intrigued by what Philip Lane had to say about negative rates. He mentioned them in two occasions last week. First, in a presentation on the international transmission of monetary policy on November 14th , he made the point that “it is plausible that the impact of rate cuts on the euro exchange rate has intensified over time, especially since the deposit facility rate moved into negative territory in June 2014”. This may not go down very well in the US where Donald Trump has repeatedly accused the ECB of consciously manipulating its currency down, but more fundamentally this may be seen as a warning from Lane that exiting the negative policy rate policy could come with a significant cost in terms of competitiveness. Originally we paid no major attention to this as the presentation was very academic in style and might not be construed as a significant monetary policy message. But on Friday in an interview he came back to it and chose to explicitly made the point that “If it is necessary to put the rate lower, we will be prepared to do so”.

There is probably some fine-tuning at work here. After the September meeting the generic noise coming from the Governing Council was that the ECB was “done” with policy rates. We actually think the policy rates have now found their effective floor but we have seen several observers going one step further and mentioning the possibility that the central bank could choose to exit from negative rates relatively quickly. The pre-announcement by the Riskbank last month that they intend to bring their repo rate back to zero in December gave this some credibility. For our part, we explained in Macrocast earlier why we think the ECB cannot as easily as the Swedish central bank make such a decision and we are not expecting any depo rate hike over the entirety of our forecasting horizon (which goes until the end of 20210. But Philip Lane may have wanted here to nip expectations of a rate hike in the bud. By playing up the possibility to go further down – even if we don’t think he could win a majority on this easily – he may at least be able to stop the debate starting too soon on bringing the deposit rate back to zero.

How much leeway for the Iberian left-wing coalitions?

The elections in Spain have not allowed the emergence of an absolute majority for any of the main blocks, but at this stage the likeliest scenario is that a formal alliance between the centre-left socialists and more radical Podemos would be the backbone of a minority government. The market has barely reacted to this. This is consistent with the continuation of the compression in spreads observed on the Portuguese sovereign after a similar alliance came to power in Lisbon in November 2015.

The Spanish coalition’s platform is for now based on a very short “pre-agreement” document. Reassuringly, its last point makes it plain that “controlling public expenditure is essential for the sustainability of the Welfare State [….] the government will launch social policies and new rights while complying with the fiscal responsibility agreements between Spain and Europe, thanks to a fair and progressive tax reform which will get us closer to Europe while eliminating fiscal niches”. So while it is clear that tax is likely to rise, there does not seem to be any temptation to go wild with the deficits. Still, while we are waiting for a more granular “government contract”, it is probably worth exploring the room for manoeuvre the new government can count on, using Portugal as a benchmark.

Seven years after the peak of the peripheral sovereign crisis, when every single successful debt auction by Madrid was hailed as a small miracle, no one is very concerned about the Spanish fiscal situation any more. And true, the deficit looks manageable, having fallen below the 3% threshold for two years in a row, which is quite a feat (it was still at 5.6% of GDP in 2015). Still, beyond the distance from the European surveillance thresholds, what is relevant in our view is to assess the solidity of the fiscal consolidation.

In Spain as in the rest of the Euro area, the fiscal stance – i.e. the change in the deficit adjusted for the impact of the cyclical gyrations – has eased since the end of the sovereign crisis (exhibit 1). The movement has been more acute in Spain than in the Euro area as a whole (deterioration of 1.3% of GDP since 2015, against 0.8%). Note that in Portugal over the last few years the cyclically-adjusted balance has continued to improve on trend. As a result, in 2018, Spain’s structural deficit (i.e. the cyclically-adjusted balance corrected for one-offs) was still the highest across the Euro area at 2.9% of GDP, very significantly higher than in Portugal (0.6% of GDP). True the bar should be higher for Portugal, since its public debt is higher than in Spain (122% of GDP against 98% in 2018), but this still suggests that Portugal has some room for manoeuvre to deal with a prolonged slowdown in economic activity. This is much harder to argue in the case of Spain. 

When looking at the breakdown in the components of the deficit, it is obvious that the main contributor to the overall decline in the borrowing requirement in Spain has been the acceleration in growth, much more so than in Portugal. What is now key is to understand how much of this acceleration is sustainable.

Exhibit 1 – Breakdown of fiscal improvement ( 2015-2019)

Source: European Commission (EC),and AXA IM Research as of 11/25/19

The macroeconomic approach of the previous centre-right governments in charge in Spain and Portugal during most of the adjustment has been quite different. Portugal was under a (tough) programme, monitored by the “troika” of the IMF, the European Commission and the ECB. Lisbon could not avoid engaging in sweeping – and transitorily recessionary – structural reforms AND a severe fiscal consolidation at the same time. Spain always took a more balanced approach to its own, market-enforced stabilisation. Madrid went very far and very quickly into sorting out the private sector which went through a brutal de-leveraging but proceeded more slowly with public finances. This has helped cushion the blow to domestic demand, but the result has been a smaller quantum of fiscal consolidation by the end of the process.

This was probably the right mix to re-start growth. Spain – just like Portugal – had to consent to a massive internal devaluation to absorb past imbalances.  In the two countries the consolidation of the corporate sector went hand in hand with a catch-up in productivity, which, combined with extreme wage moderation, produced a spectacular rebound in competitiveness. The subsequent positive effect on GDP growth was higher in Spain than in Portugal partly because the fiscal contraction was less severe, but both countries ended up outperforming the Euro area average.

Still, looking ahead it is not obvious the two countries can count on the continuation of such out-performance. After the post-crisis catch-up, productivity growth slowed down (Exhibit 2) and wage moderation eased (Exhibit 3). There is no actual deterioration in competitiveness because precisely at the same time unit labour costs started accelerating in the rest of the Euro area and significantly so in Germany. But in these matters the second derivative, not just the first, matters. The Iberian countries are no longer making significant competitiveness gains. This means that their export performance is going to converge back to the pace of the currently slowing external demand, without the improvement in market shares they had been enjoying as part of the internal devaluation.

Exhibit 2 –The productivity catch-up is over

Exhibit 3 – Strong wage growth in Germany offers some leeway to peripheral countries

Some of the changes in macroeconomic management in Spain are structural. For instance, the labour market has been made more flexible thanks to new legislation significantly curbing severance payments for new working contracts. But some of them are not embedded in the legal framework but are essentially the result of a new approach by the workers unions. Wage moderation, and for instance the provisional shift in indexation from past inflation to a GDP growth target, was accepted by the unions at the worst of the sovereign crisis. With the memory of the twin recession fading, the unions will normally become more demanding, at a time when the government shares their focus on improving labour income – demonstrated for instance in the massive 22% hike in the minimum wage at the beginning of 2019.

In a nutshell, the macroeconomic room for manoeuvre open to any government emerging from the latest general elections in Spain should not be over-stated in spite of the strong growth observed in the last few years. In Portugal, the agreement between the socialists and the radical left recognised those limits when the centre-right lost power four years ago, and under their stewardship the structural deficit continued to improve. They also refrained from major shifts on income policy.

The political situation in Lisbon differs however from what it would be in Spain: in Portugal the radical left supports the government “from the outside”, while it seems likely that Podemos would actually participate to the cabinet and may thus exert more influence. And even in Portugal it may be difficult to resist outside pressure: upon being re-appointed Prime Minister for normally a 4-year term last month, Antonio Costa announced a gradual increase in the minimum wage by 25% by 2023. This is quite relevant for Spain as well. Both PSOE and Podemos may be well aware of their fiscal limits, but there may be pressure from the “rank and file”. A specific issue in Spain is that government spending is actually relatively low by European standards (see Exhibit 4). For instance, even though the unemployment rate there is significantly higher, social protection still stands from a lower share of GDP. A “convergence theme” could very well emerge.

Exhibit 4 – Breakdown of public spending

Again, it is difficult to assess how far those limits are going to be tested as long as we do not have a full government contract. The reference to the European fiscal rules in the pre-Pact is reassuring. But we suspect we – and the market – will monitor Spain more closely in the months ahead.

UK: it’s a two-horse race again!

According to the Britain Elects aggregator, on November 23rd the latest available polls put the conservatives at 42.4% on average against 29.6% for Labour. On November 16th the gap was narrower (39.6% against 28.8%). What is probably more striking is the steep fall for the Brexit party (now below 5%) and for the Lib-Dems to a lesser extent (now below 15%). The race is polarising, but for now at least the conservatives are gaining more from this polarisation than Labour.

Boris Johnson has sought to further deprive the Brexit party of electoral oxygen by releasing on Sunday a manifesto making it explicit that a conservative government would not “accept an extension” of the transition period, normally ending at the end of 2020. This decision may be wise from a short term tactical point of view but this may come back to haunt a conservative administration next year. Indeed, negotiating in one year a free trade agreement with the EU, which is supposed to be the basis of the long-term relationship between the UK and the EU,  is going to be daunting and this is likely to generate quite some noise.

Beyond Brexit, we note that the conservative manifesto was not as spendthrift as could have been feared. The relaxation of the fiscal “golden rule” will allow for an additional public investment effort of roughly 1% of GDP annually in the next four years, funded by extra borrowing, but the new plans for current spending and tax lead to a mere re-profiling over the next four years of the surplus within the same global envelope as before. The deficit will rise, but Boris Johnson has resisted the calls of the “populist Brexiteers” and is refusing to engage in a race with Labour on who will be the biggest spender.

This may be prudent, but at the same time we did not find in the manifesto any overarching macro strategy post-Brexit. It seems that the “Singapore on the Channel” project has been shelved, but it is unclear what is going to replace it. Mothballing a planned cut in the corporate tax is clearly a convenient way to balance the books while raising spending on healthcare, but it is hardly going to make the UK more appealing to foreign investors post-Brexit.  

Upcoming events
US: Mon: Fed Chair Powell speech; Tue: Conf Board consumer confidence, new home sales; Wed: Q3 GDP (2nd est), PCE inflation, pending home sales, Fed’s Beige Book, Thurs: Thanksgiving
Euro Area: Mon: German IfO business climate index; Wed: French INSEE consumer confidence; Thu: prel. German HICP and CPI; Fri: Eurozone flash CPI estimate, German and Italian unemployment
UK: Thu: Sky News Leader debate incl. Swinson; Fri: GfK consumer confidence, mortgage approvals, BBC seven-way debate; Expected: Conservative GE manifesto
China: Sat: Official Manufacturing and non-manufacturing PMIs
Japan: Thu: Industrial production

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