Commission forecasts paint a less than optimistic picture for eurozone outlook

The European Commission has this morning released its Autumn 2014 Economic forecasts. While these forecasts can often be quite mundane owing to the very managed message they are trying to send, this set look to be a bit different (see here for our take on Winter 2014 and Autumn 2013). Maybe unsurprisingly the tone to more sceptical, critical and possibly realistic. Below outline some interesting themes.

Another downward growth revision
Once again growth for the Eurozone has been revised down. The previous forecast saw 1.2% and 1.8% growth in 2014 and 2015 respectively. The new forecast predicts 0.8% and 1.1% respectively, quite a significant downward revision, especially since growth next year is now expected to be below the original forecast for this year. The initial blame (in the press release) for this revision seems to be laid at the feet of “increasing geopolitical risks and less favourable world economic prospects”. However, that raises the question of why it is seen as enduring up to 2016. In the report itself the assessment is thankfully more candid highlighting “incomplete internal and external adjustment” and “low productivity gains”.

More realism about the labour market
There is a wider acceptance in these forecasts that unemployment will remain elevated for some time and that differences in labour market performance will persist. That said, at the moment any real prospect on employment growth in the Eurozone seems optimistic.

Bad news in nearly all the large economies
France and Germany’s growth prospects for this year have been revised downwards to 0.3% and 1.3%, from 1% and 1.8% respectively. Italy is expected to contract by 0.4% this year and only grow 0.6% and 1.1% in 2015 and 2016 respectively. Given that these three countries account for nearly 60% of Eurozone GDP this suggests a very poor outlook for the Eurozone with growth risks tilted to the downside. In general, the core vs. periphery split is less clear in this report, at least in growth terms as many countries are now acting as a drag on the Eurozone economy for a number of reasons.

Significant and increasing reliance on domestic over external demand
Early on in the crisis there was a clear focus on facilitating export led recoveries, often in the German model. However, over the past 12 – 18 months this has shifted, possibly driven by global economic weakness, and these forecasts finalise the shift. The Commission itself says,  “Net exports are likely to contribute only marginally to GDP growth over the forecast horizon”. Spain is a prime example of this, see here for a longer discussion of the issue.

While finding a balance between the two is important (we cannot have 18 Germanys in the Eurozone) the shift may have been too stark. Let’s not forget that there is still a huge amount of public and private debt (both household and corporate) in the Eurozone, especially in problem countries. This will limit potential domestic demand growth. So while the flows are shifting in a way which should see an uptick in domestic demand, we should not forget that the huge stock of debt may provide a ceiling on this as a driver of growth.

Low inflation is here to stay
The Commission has also downgraded its inflation forecast with CPI expected to be 0.8% in 2015 compared to previous forecast of 1.2%, while it is only expected to be 1.5% in 2016. The forecast for 2015 is below the ECB’s of 1.1% but the 2016 is above the ECB’s which is 1.4%. Interestingly, the Commission continues to make the case that “low, or negative, inflation rates as part of [some countries] inevitable adjustment process”. This is an argument which has been absent all recent ECB press conferences. In terms of deflation, the Commission sides with the ECB, saying the risks of outright deflation remain low.

We’ll update the blog throughout the day as we pour over the 185 page report. But for now, we’ll leave you with a thought from Commissioner Jyrki Katainen in the press conference, when asked how much the forecasts can be trusted given a history of being incorrect he simply responded, “Nobody knows”. Quite.

ECB preview - Dovish Draghi to double down on easing?

The European Central Bank (ECB) holds its monthly meeting in Frankfurt today - the day after ECB President Mario Draghi's 67th birthday.

As usual, Open Europe's Head of Economic Research Raoul Ruparel has published a preview on his Forbes blog, explaining what we may expect from today's meeting.

Here goes:

Following ECB President Mario Draghi’s dovish speech at Jackson Hole last month this week’s ECB meeting has taken on new importance. This has been further enhanced by the recent Eurozone inflation data which put annual CPI at 0.3% in August. The headline figure hides some of the story with core inflation actually rising to 0.9% (from 0.8%) but the ECB’s previous inflation forecasts have begun to look increasingly out of line with reality.

However, those expecting a big move are likely to be a bit disappointed. As I pointed out last month, it is almost nonsensical for Draghi to unveil new measures before his previous policies have been implemented. I am thinking specifically of the TLTROs (targeted long term lending operations) the first of which will only be conducted on 18 September. Any big announcement now could undermine the predicted take up of these measures – which clearly remain the ECB’s preferred approach for injecting further liquidity.

That being said, these measures are unlikely to make much difference since the conditions for passing liquidity on to the real economy remain very loose. They are also very unlikely to appease investors and markets which have now come to expect some significant new easing. The two key options which are on the table for this meeting are:

1. A further interest rate cut: Many will validly ask, what is the point in a further cut now? Of course it would have little to no economic impact, however, it would once again signal the dovish bias of the ECB. It would also signal a clear shift in the ECB’s position given that Draghi has previously said rates are unlikely to get any lower than current levels. It becomes another mechanism to express his commitment to further easing. There also remains scope to make the negative deposit rate more negative, although there is a cap on this since, at some point, it will be cheaper for banks to simply hold cash than deposits with the ECB.
    
2. Purchases of private sector assets – specifically Asset Backed Securities (ABS): The ECB has long telegraphed such action and it is the next obvious tool at its disposal. Whether or not it will be announced this month or in the coming months is a bit of a toss-up. It seems the ECB is not quite ready to implement it yet and has made a big song and dance about the need to adjust regulations and definitions of ABS, which are yet to fully take place. Whenever it is announced, implementation is likely to be later this year to allow the negative deposit rate and TLTROs to have time to work. I remain sceptical on the effectiveness of this policy, which I have analysed in detail on the Open Europe blog. Ultimately, the market for the transparent ABS related to SME loans remains very small in Europe and focused in the core countries rather than the periphery (where this money really needs to flow to). For example, in Q1 2014, of the €18.5bn in ABS issued, only €1.6bn used SME loans as collateral. The ECB maintains that it can and will help create the market in this area, yet with this measure having been forecast for some time, you would expect there to have been some market response already.

As with many of Draghi’s press conferences, all of this will be weaved into a dovish speech including a few key trigger words for markets – few other central bankers are as adept in their communication. As for full blow Quantitative Easing on sovereign debt, this remains someway off in my mind and hurdles remain high. Its use will ultimately be tied into developments in the fiscal and political sphere, as hinted at in Draghi’s speech (more detail on this coming in a future post). The ECB will be loath to unveil QE, which it fears can only buy time, without further commitment to reforms, a clearer fiscal approach and developments on the structure of the Eurozone which such changes will entail.

Have borrowing costs in the eurozone periphery come down too far, too fast?

Over on his Forbes blog, Open Europe’s Raoul Ruparel asks: is there a bond bubble in peripheral Europe? The thurst of his answer is that, while there are good explanations for why costs have come down so far and so fast, they could certaintly have side effects, not least because people misinterpret the reasons for the move. The full post is here, but below are the key points:

What is driving this and is it a bubble?
There are three key factors at work here:

1. ECB President Mario Draghi’s promise to do “whatever it takes” to protect the euro combined with the unlimited bond buying policy of Outright Monetary Transactions (OMT) has driven borrowing costs down since mid-2012. This effect has been amplified by the expectations of further ECB easing, particularly some form of Quantitative Easing (QE), which would bring yields down even more.
2. There has been some success in terms of eurozone reform, particularly with the successful end to the Irish and Portuguese bailouts as well as these countries’ return to the markets, along with Greece. The eventual agreement on banking union and other aspects of trying to correct the structural flaws in the euro (although I believe it is far short of what is needed) has also contributed to the positive sentiment.
3. Possibly the most important factor though is the very low inflation in the eurozone (and even deflation in some countries). Over the past six months this has pulled the borrowing costs across the eurozone down.

This final point is driven home by looking at the rough and ready version of the ‘real yield’ on ten year debt in Europe (10yr yield minus HICP inflation). As the graph below highlights*, when this is done the UK actually borrows at a real rate which is 2% below Ireland’s.

Could this present a problem? (Hint: Yes)
While the process of collapsing bond yields in peripheral Europe is explainable it does still present some serious causes for concern.

• The huge demand for peripheral bonds does seem to have gone too far with respect to the economic fundamentals of these countries. Debt levels have continued to rise – exacerbated by low inflation – while many countries are barely posting any economic growth.
• More concerning though is that this creates very perverse incentives. Many governments can already be seen professing the success of their policies, citing falling borrowing costs and buoyant financial markets. In reality, these are much more down to the ECB and inflation effects mentioned above.
• The risk is that complacency seeps in (some of which can already be seen) and that the reform process in these countries stalls. Italy and France are prime examples of this. While the European Commission does have additional powers now to encourage further reform, when push comes to shove there is little it can do to force reform on an unwilling political class and population, particularly one with low borrowing costs.
• As detailed here, the banking union looks insufficient to break the sovereign banking loop in the eurozone. The efforts to improve the structure of the eurozone have slowed, the risk is they will grind to a halt until the threat of a crisis returns.
• The performance also looks strange relative to countries such as the US and UK which have always borrowed in their own currency for which they are solely responsible and have clear fiscal and central bank backing. Even with the changes to the euro structure and the ECB promises it’s hard to say that, in another crisis, the same issue wouldn’t arise with regards to a comprehensive lender of last resort (let’s not forget, the OMT comes with plenty of conditions and is limited in scope). Even though accounting for the inflation impact, the difference in risk between peripheral eurozone countries and the likes of the US and UK does seem to be being underestimated.

Ultimately, the crisis highlighted that too much price convergence without economic convergence and reform in the eurozone can actually be a bad thing, with resulting perverse incentives and negative outcomes. While the price action in peripheral bonds might not yet count as a ‘bubble’, investors and politicians would do well to remember these lessons when interpreting the record low borrowing costs.

Expectations and pressure mount for ECB action

This could easily be a standard monthly headline. As before the past four or five ECB meetings, the questions of deflation and further easing are once again weighing on the ECB Governing Council and the markets.

Over the past month the market has come full circle from essentially ruling out any further ECB action to almost expecting some purchases of assets (both accompanied by the respective strengthening and then weakening of the euro exchange rate).

This was topped off today with the latest inflation data which showed that inflation in the eurozone has dropped to its lowest level for five years (annual rate of 0.5%).

A couple of points to note on this data:

• While energy prices are still the largest driver of the contraction, unlike some previous months, core inflation (without energy, food prices or tobacco) has also fallen. This may encourage the view that the decreases are not simply due to short term shifts in commodity prices.
• That said, the core inflation rates remain above where they were in November 2013 when the ECB previously cut rates.
• Other national inflation data has been quite weak – Spain moved into outright deflation in March, while German inflation was running at only 1%.
• As Gavyn Davies noted on twitter, the 0.5% rate falls outside of the ECB’s March projections for inflation this year and up to 2016. This raises questions about whether the inflation rate is still on the upward path forecast. Combine this will the volatility and tendency to strengthen of the euro and the ECB’s projections do not seem to be holding up too well.

The other aspect adding weight to expectations has been dovish comments by ECB members, notably by Bundesbank President Jens Weidmann. Many believe this has “opened the door” to significant action by the ECB. Open Europe’s Raoul Ruparel addressed this issue on his Forbes blog on Friday arguing:

“The real issue from a German perspective is not necessarily that the door was ever firmly closed (or open) but that we remain someway from the QE door and to get there would require carefully negotiating some politically and legally explosive obstacles.”

He concludes:

“In the end, I think we find ourselves in a fairly similar position to last month (albeit having gone through a cycle of over scepticism and now over optimism) – further action remains possible but not yet highly likely.”

This meeting will be another one to watch but so far the ECB seems strongly wedded to its new communication and forward guidance policy, which it believes can allow greater control over rates markets, it is not yet clear whether it is willing to abandon this approach or push it over the barrier into full on policy action.

ECB stands firm but looks to wider measures

Over on his new Forbes blog, Open Europe’s Head of Economic Research Raoul Ruparel lays out his take on why the ECB decided to stand firm despite the apparent deflation threat,

“My feeling is that there are two broad reasons. The first being that the flow of data is mostly positive, and the second, more important factor, being that none of its tools are economically, politically or legally suited to tackling the low inflation environment in the eurozone.”

He concludes,

“All in all then, the tools at the ECB’s disposal are far from suited to helping push up inflation in the struggling countries and boosting lending to the real economy to help economic growth. This is not to say the ECB would never use them, but that are better suited to a deeper more acute crisis (such as a break-up threat) than the chronic long term malaise which the eurozone currently finds itself in.”

These are themes we’ve explored plenty of times on this blog so won’t rehash here.

But there were a couple of other interesting points to come out of ECB President Mario Draghi’s press conference though.

The first being his mention of a new dataset which the ECB is looking at, specifically the “the high degree of unutilised capacity” in the eurozone economy. This refers to the ‘output gap’, i.e. the amount by which GDP in the eurozone has fallen below potential GDP. As you might imagine, estimating such a gap is fraught with difficulty and estimates are notoriously revised retrospectively (for example before the crisis few economies were seen performing above potential despite huge financial, real estate and debt bubbles).

Why is this important? Well, it could be the first step towards a more firm GDP target on the part of the ECB. Admittedly, it’s a small step and a full GDP target is unlikely but it could be an interesting shift for the ECB which has traditionally focused more on inflation, money market and private sector survey data (such as the PMIs). As Draghi himself said, it also shows that monetary policy will stay looser for longer, even if the data improves, due to the large gap between actual and potential GDP. It will be interesting to watch how this one develops over the next few meetings and whether the ECB decides to put any more emphasis on this measure.

Are further falls in inflation putting more pressure on the ECB to act?

Friday saw the release of the flash estimate for annual inflation in the eurozone in January. It dropped further to 0.7% - well below the ECB’s target of 2%.

The initial reaction was that this will increase pressure on the ECB for action at this Thursday’s Governing Council meeting. While that is true on the surface its worth keeping another couple of points in mind.

• As the graph above shows (click to enlarge), much of the recent decline has come from changes in energy and food prices. Core inflation, excluding these two factors, has been relatively stable since October and has been on a gradual decline since spring 2013.
• Now of course, many will point out that energy and food are important components of real world costs and therefore should not be discounted. This is a valid point, but here we are looking for insight into how the ECB takes its decisions. Generally, the ECB will be less concerned over short term moves in energy and food prices and is therefore less likely to take action off the back of this.
• The main part of the decline took place last year and has been happening for some time – this is likely already accounted for in the ECB easing efforts.
• While the inflation data may not push the ECB to act, there are plenty of other concerns. The turmoil in Emerging Markets could push the ECB to provide an additional liquidity buffer against any shocks. While this morning’s PMI manufacturing data was actually very positive for the eurozone, data on lending to the real economy and growth of the money supply is less so.

As we have suggested before, some further easing is looking likely. The real question is when and how? The data suggests to us that the ECB will wait until its March meeting and its updated inflation forecasts to make a judgement – but then again it went a month earlier than expected in November.

As for how, the most likely tools remain some form of targeted LTRO and/or purchases of bank loans but both programmes would require significant work and have numerous shortcomings, as we have already noted.

A peek inside the ECB’s toolkit

Despite being barely a month into 2014, there have already been countless column inches written about the ECB and President Mario Draghi’s potential actions during 2014 (mostly to tackle the ‘deflation ogre’).

Is the ECB toolkit empty?

As we have noted before, while the ECB has an extensive toolkit in the case of an acute crisis, it has so far struggled to find the right tool (if one exists) to help promote lending to the real economy and therefore economic growth.

The favoured policy, widely cited by commentators and mentioned by Draghi previously, is some form of targeted liquidity scheme linked to lending to the real economy – along the lines of the Bank of England's 'Funding for Lending' scheme.

Such an option remains possible, but as Bundesbank Chief Jens Weidmann has pointed out, difficult to implement. We have noted this before, but, given that the ECB is already running unlimited liquidity at near zero interest rates (on loans up to three months) it’s hard to see that there would be huge demand for longer loans tied to specific lending requirements.

Over the weekend, speaking at the World Economic Forum in Davos, Draghi revealed another potential policy – ECB purchases of bundles of bank loans (aka. securitised bank loans or asset backed securities).

Is this a real option?

• The ECB has previously purchased covered bonds and government debt on the secondary market. Hence, securitised bank loans should be possible in theory.
• However, as Draghi himself admitted, the market for such securities remains seriously underdeveloped in the eurozone.
• The idea seems to be in its early stages, and probably requires a lot more discussion within the ECB.
• The move would likely face significant opposition within the Bundesbank, and Germany more generally. This would probably be focused on the risks involved in such asset-backed securities, which are often opaque and continue to have a negative connotation due to their role in the financial crisis.
• These are the reasons why Draghi has previously shied away from direct action in this area, instead suggesting that it is an area for the European Investment Bank (EIB) to act. There have been comments suggesting that work was underway on a joint programme, but nothing ever emerged.

Would it be effective?

• At the moment, no. The market remains significant underdeveloped. According to the Association for Financial Markets (AFME) the outstanding securitisation market is €1,545bn - only €131bn of which related to small business loans, while the very large majority of which relate to Retail Mortgage Backed Securities (RMBS) probably from the UK and Netherlands. While Draghi is probably right in his suggestion that it would develop in response to any ECB action on this front, it has a long way to go.
• Data from AFME give some flavour for the securitisation market in Europe. As the tables below show, the market remained small over the past few years, with less than a fifth of last year’s issuance relating to lending to Small and Medium-sized Enterprises (SMEs).

• Furthermore, in terms of the location of collateral, the markets remain very underdeveloped in the countries which the ECB would likely want to target. The UK and Netherlands account for a large chunk of the European market. Italy and Spain do have some market presence, but it remains small compared to the size of their economies (although this is true for the sector in general).

• The final point to note is that the structure for such securities remains opaque and undefined. Given that they are bundles of various technical products, they will always be difficult to value, and while credit rating agencies have improved their processes, questions will still be asked as to whether their ratings truly reflect the risk and value of these products.

While this option looks to be some way off then, the fact that Draghi felt the need to bring it up will likely encourage the view that the ECB will take some further action in the coming months.