Summary

The widespread deterioration in economic data across the Eurozone is very concerning.  For several months, now, key metrics such as industrial orders, PMI, and various business surveys have been lower in Germany, France, Italy and Spain.  This slowdown appears to be spreading quickly amid evidence of weakening indicators throughout the region. We believe the economic picture is fragile enough to not merely remove the spectre of rate rises, but also boost the case for further quantitative easing from the European Central Bank – a discussion we think can come back on the table in coming weeks. 

We think that the ECB should use its remaining policy firepower to prevent recessionary forces becoming entrenched, taking into account the impact of populism and the succession of the ECB presidency on policy timing.  We see the central bank re-opening its purchases of corporate bonds, and forecast a return to negative yields for German 10y Bunds in the next 3-6 months.  The economic environment and potential response could create a positive backdrop for high quality European credit, but European equities could remain on the backfoot. We see the euro remaining rangebound against the dollar, due to competing factors emanating from the US slowdown that prevent sharp variation either way.

 

Eurozone economy loses steam

We have serious concerns about the slowdown in Eurozone growth.  While still positive, GDP growth for the region is losing steam rapidly, and we expect it to fall significantly below trend.  This pullback takes into account an easier picture in terms of consumer spending, net exports, business investment and inventories.  Composite PMI indicators show a generalised slowdown across France, German, Italy and Spain, with indications that some economies might stagnate in early 2019.  At the same time, industrial production is declining in the four major economies.

Taking Germany as an example, we note that industrial orders have fallen 1.8% from October to December, with a prominent 4.6% drop in foreign orders (especially towards non-EMU countries), not to mention a negative trend in domestic orders, too.  While something of a bounce was expected for the December industrial production figures, the numbers disappointed, coming in softer than expected at -0.4% mom, albeit with upward revisions to the November number.

We also note that the drop in manufacturing PMI to 49.7 in January (below the expansionary boundary of 50 for the first time since mid-2013) is a further signal that the downward trend in industrial activity could be poised to continue, particularly with the new orders component of the survey as low as 45.3.

Forward-looking expectations in business surveys compound the picture of stalling growth.  The German IFO indicator of business expectations plunged to 94.2 in January and is notably below the 100 mark.  This forward-looking indicator contrasts with the IFO current assessment, which remains more stable above 100, at 104.3 in January.

Other future risks to the Eurozone could emanate from trade disputes.  While investors remain focused on the US-China trade war, trade tensions between the US and the EU could flare up again in coming months, especially once a deal between China and the US is reached.  Should Europe be drawn into the trade war, it would act as a further headwind to the European economy – we are watching such developments closely.

Turning to inflation, we note that Eurozone core inflation has been undershooting the ECB’s main target since 2007-2008, despite the reduction in the deposit rate to -40bps, several rounds of low-interest LTRO and TLTRO loans to banks, and €4.7trln of asset purchases.  Inflation near or less than 2% is the main mandate of the central bank.  At recent meetings, the ECB has been keen to stress it has tools left in its policy arsenal, though it’s hard to see where another ‘big bazooka’ would come from given the policy already meted out.

 

Resurrecting QE: discussion waiting to happen

Against this extremely soft economic backdrop, we do not believe the ECB will hike rates in the Eurozone anytime soon.  In fact, we increasingly see the ECB as having missed the opportunity to hike at all this year, and possibly in this cycle.  The ECB will update its economic forecasts at its next meeting on 7 March, an update that will be key to gauging how the bank views the slowdown.

Should the indicators tip more firmly towards recession, however, it will be important to assess the instruments available to the central bank, especially after the past decade of robust monetary accommodation. Should the recession prove mild, an additional EUR1.0 to 1.4 trillion of additional quantitative easing, probably in corporate bonds, might be sufficient.  This compares to the current ECB balance sheet of EUR4.7trln after the bank officially ended new purchases as part of its asset purchase programme in December 2018.

Given the sharp downturn in indicators, however, we are acutely aware that the ECB’s tools could be insufficient to blunt a deeper recession, should that take shape.  This could pose an existential threat to the capacity of monetary policy to tackle the slump, especially if fiscal policy is not forthcoming.

As such, we believe that the next step could be another QE programme with a stronger emphasis on corporate bonds.  We also note recent reports of potential increased fiscal stimulus from various Eurozone countries and venture that a deep recession could require response on both monetary and fiscal policy fronts.  More imminently, we expect the ECB to unveil another round of TLTRO loans to banks at low rates in order to stimulate on-lending in the region by providing continued liquidity support.  We note that ECB member Benoit Coeure reiterated recently that the bank is discussing a new TLTRO operation, and we believe the bank could unveil such an operation at the next 7 March meeting when it updates its economic forecasts.

 

Added factors: populism, succession

The monetary policy response is further complicated by the rise of populism in Europe.  Such risks abound from the ongoing Italian budget debacle, the gilet jaunes protests in France, the potential for populist gains at the upcoming European Parliament elections in May, and Brexit uncertainty as negotiations go down to the wire.  We feel that the rise of populism could exacerbate the political need to address the recession probabilities and, ideally the ECB should aim to prevent such probabilities early.  In this atmosphere, the central bank should understand its mandate could be jeopordised, and needs to optimise its available policy tools to reduce the probability of recession before it becomes entrenched. 

Lastly, we note that succession issues are materially important in the ECB’s timing because the current President, Mario Draghi, will complete his tenure in October 2019.  News reports citing ECB sources report that the council could wait until a new President is in place before materially changing its stance.  In our view, the leading contenders to succeed Draghi are Bank of France Governor Francois Villeroy de Galhau, and former chief of the Finnish central bank Erkki Liikanen. 

We see a low likelihood of Bundesbank President Jens Weidmann being appointed and note his recent remarks that central banks should interpret their mandates narrowly in order to defend independence – we think this is wrong footed given the current structural and cyclical economic context.

Our call on yields: We see 10y German Bund yields falling to -20bps in the next 3-6 months, compared to +14bps currently, and to the July 2016 previous low of -20bps.  Should this return to negative yields play out, it would signal the bond market pricing in the ECB adopting a more dovish stance and potentially expanding QE, as well as possibly confirming the need for fiscal stimulus.

 

Investment Implications: Should the market begin to price in further accommodation from the ECB, and in particular an extension of QE, high quality European credit has the potential to rally. European equities, however, should remain on the backfoot until growth stabilizes.  We see the euro remaining rangebound against the dollar, due to competing factors emanating from the US slowdown that prevent sharp variation either way.  Our view on emerging market assets is reinforced by the dynamics in developed markets. A slowing US environment combined with a struggling Europe is likely to push flows towards emerging market assets. As a potential illustration, USD23.1bn flowed into EM bond and equity dedicated funds in January, indicating a significant rebound of uncertainty that gripped the region from the second half of 2018.