Today’s CIO Weekly Perspectives comes from guest contributor Patrick Barbe.
With the U.S. Federal Reserve chair’s Jackson Hole commentary striking a tone that was slightly hawkish on tapering but slightly dovish on rates, attention now turns to this week’s European Central Bank policy meeting.
Could it follow the Fed’s lead and signal the tapering of asset purchases this year? Does that imply anything about the path of interest rates? And should we expect a resumption of Bund yield normalization?
Pillars of Support
Since suffering a double-dip recession last winter, Eurozone GDP growth has exceeded expectations. Official forecasts now expect output to be at pre-pandemic levels by the end of 2021, with growth of 4.8% this year and 4.5% next year. We anticipate more than 5% growth in both 2021 and 2022.
We see two major pillars of support.
The first is consumption. Despite social restrictions, unemployment and hardship have remained low relative to the size of the recession. Many Eurozone governments provided fast and comprehensive economic support while many companies furloughed workers rather than laying them off—particularly after rehiring proved difficult when restrictions were lifted last year. European consumers have largely been able to save and retain their confidence.
The second pillar is capital expenditure. Low growth expectations and concerns about the integrity of the Eurozone held back capex in the decade after the financial crisis of 2008 – 12. The European Union’s joint fiscal response to the pandemic, and specifically the €750 billion Next Generation EU Fund, finally appears to be unblocking that pipeline.
The Fund’s loans and grants, which started to be released in July, are designated for improvements to public administration, education and supply chains, as well as green-growth investments. This is likely to spur capital-intensive productivity and efficiency enhancements across multiple sectors. Furthermore, we believe these investments could narrow the North-South growth gap, mitigate youth unemployment and, as a result, continue to reduce the allure of populism in Germany, France and Italy.
Labor’s Bargaining Power
Is all of this inflationary?
It may look that way at the moment. Last week, the latest preliminary estimate for Eurozone inflation came in at 3%, the highest since November 2011 and substantially higher than the ECB’s 2% target. Inflation in Germany is as high as it has been since summer 2008.
We do see early signs that labor is regaining some bargaining power, particularly in the skilled sectors required for infrastructure development. Unions that became used to trading wage hikes for job stability are now demanding pay that keeps up with inflation—and in some cases threatening work stoppages when it is not forthcoming.
That said, we believe much of the current inflation spike is due to supply-chain adjustment as economies reopen. Ultimately, we anticipate stabilization around 2% in 2022, as opposed to the 1.3% average rate characteristic of the last decade. The ECB’s latest forecasts put inflation at 1.5% in 2022 and 1.4% in 2023.
In terms of what this could mean for policy, we have already had strong suggestions, particularly from the ECB’s Chief Economist Philip Lane, that tapering of the Pandemic Emergency Purchase Program (PEPP) could be announced as soon as this week’s meeting and start in the fourth quarter. We think this is likely, and that the PEPP will be closed out by March.
We do not think this implies anything about interest rate policy, however, particularly following the distinction drawn between asset purchases and rates by Jerome Powell at the Jackson Hole conference.
Recently released minutes of the ECB’s July meeting reveal some concern over how to interpret the central bank’s new forward guidance framework. A “few” Governing Council members worry about how far and how long inflation might be allowed to overshoot in order to maintain “lower-for-longer” guidance.
Nonetheless, we think a decision on rates is highly unlikely before next spring, when the nature of current inflation is clearer. Should it prove mostly temporary, the ECB’s framework for interest rate decisions—no hikes until it “sees inflation reaching 2% well ahead of the end of its projection horizon and durably for the rest of the projection horizon”—implies that a rate hike could be off the table until 2024.
Overly Pessimistic Pricing
It is in bond markets where the U.S. and Eurozone stories could diverge.
The subdued move in U.S. Treasury yields following Powell’s Jackson Hole commentary suggests that his upbeat economic assessment and policy statements were already priced in. By contrast, we think Bunds yielding -0.35% remain priced for an overly pessimistic view on growth and inflation.
There are risks ahead, but we believe they are modest. The Delta variant of COVID-19 could see a return of restrictions, but these are likely to affect only service industries that are of lesser importance to the region’s growth momentum. Germany could require a three-way coalition to form a government after federal elections later this month, but while negotiations could drag on and cause some uncertainty, none of the likely combinations appear to pose substantial economic or market risk.
Bund yields climbed as high as -0.09% in May, and we think they are likely to be back to zero by the end of this year. For fixed income investors, Eurozone credit therefore presents considerably less downside risk given the current outlook, in our view.
In Case You Missed It
- Eurozone Consumer Price Index: +0.4% in August month-over-month and +3.0% year-over-year
- S&P Case-Shiller Home Price Index: June home prices increased 2.0% month-over-month and 19.1% year-over-year (NSA); +1.8% month-over-month (SA)
- U.S. Consumer Confidence: -11.3 to 113.8 in August
- ISM Manufacturing Index: +0.4 to 59.9 in August
- U.S. Initial Jobless Claims: +340,000 for the week ending August 28
- U.S. Employment Report: Nonfarm payrolls increased 235,000 and the unemployment rate decreased to 5.2% in August
- ISM Non-Manufacturing Index: -2.4 to 61.7 in August
What to Watch For
- Tuesday, September 7:
- Eurozone 2Q 2021 GDP (Final)
- Japan 2Q 2021 (Final)
- Thursday, September 9:
- European Central Bank Policy Meeting
- U.S. Initial Jobless Claims
- Friday, September 10:
- U.S. Producer Price Index
– Andrew White, Investment Strategy Group