Macro Weekly – Why Draghi is right

by: Han de Jong

Big Picture - 5 October 2014 - Why Draghi is right.pdf ()

Equity markets responded very negatively to the ECB’s decision not to engage in large scale purchases of government bonds, allegedly raising fears for stagnation, recession and deflation. They are wrong. While the economic situation is far from brilliant, the eurozone economy is more likely to gain momentum in the period ahead than to lose altitude. Painful deflation also remains only a remote risk. The necessity for the ECB to do full-blown QE have been exaggerated in the (Anglo-Saxon?) media. As an aside, it is interesting to note that while the equity market responded violently to the ECB’s decision, other markets reacted much more calmly. High yield bonds, for example, hardly moved.

The hype

When you follow the media you get the impression that the global economy is performing very poorly, that the eurozone is about to fall back into stagnation or recession and that deflation is almost inevitable in the eurozone. Geopolitical worries are mounting and growth in emerging economies continues to disappoint. Because of this, the ECB should start large scale purchases of government bonds, according to many commentators. Remarks made by ECB President Mario Draghi had fed expectations of fireworks at the ECB’s press conference last week. It did not happen.

I see a largely different world. True, global growth is un-spectacular but it is not too bad either. We always knew that the recovery following large financial crises tends to be sluggish as the process of balance-sheet repair, which puts a lid on economic growth, is slow and lengthy. So, what did you expect?

The US economy is recovering nicely, largely in line with our expectations. Last week’s data was perhaps a little mixed, but business confidence remains high and the latest employment report shows that the improvement in the labour market is continuing. The US economy added 248,000 jobs in September while there was an upward revision of 69,000 for the previous two months. The unemployment rate fell to 5.9% (the lowest since 2008) from 6.1% in August as the labour force shrank.

The eurozone has produced some disappointing data in recent months. Business confidence, in particular, has weakened. I have argued here before that it would be unusual for the eurozone economy to sink back into the mud while the US continues a reasonable recovery. ‘Unusual’ does not mean impossible, of course, but there must be good reasons for such a divergence to occur. And right now, I simply cannot see sufficient reasons. Indeed, I would argue that the current situation isn’t quite as black as particularly the Anglo-Saxon media make it out to be (it saddens me that much of the local press in Holland is following their lead). While some data has been weak in the eurozone, several other data has actually improved. Retail sales, for example, are clearly on an upward trajectory. Although this data is volatile and prone to material revisions, the August report on eurozone retail sales was strong. The volume of sales was up 1.9% yoy, equalling the growth rate seen in June. During the economic recovery of 2010, the growth rate of retail sales never exceeded 1.6% yoy. The last time sales growth was stronger than in August was in 2007! Unemployment is obviously worryingly high, but it has been coming down for a while.

Tailwinds will make themselves felt

Furthermore, and perhaps even more importantly, the eurozone is likely to feel increasing support from a number of important tailwinds. First, the ECB bank lending survey shows that banks are no longer tightening their lending criteria, but have now started easing them a little. The same survey shows that credit demand is finally rising and this improvement is occurring across the board: consumer credit, mortgages and corporate loans.
Second, the euro has fallen almost 10% against the dollar since its peak in May. On a trade weighted basis, the euro has lost less than that, but the improved competitiveness will gradually affect export performance.
Third, yield curves have collapsed over the last year. Yields on 10 year Spanish and Italian bonds, for example, have dropped over 200 bps during the last 12 months. The same is true for 5 year bonds, while even 2 year yields have fallen significantly. The yield drop on Portuguese bonds has been even more spectacular: an average of 400 bps (!!!) between 2 year bonds and 10 year ones. Undoubtedly, only a fraction of these drops have worked their way into the economies, but lower borrowing costs and improved sustainability of public finances will have a positive impact on economic activity.
Finally, commodity prices have dropped in recent months after they had risen in the earlier part of the year. The lower euro is, perhaps, a limiting factor here, but the overall impact on economic activity should still be positive.

All these tailwinds will make themselves felt, but it will be a gradual process. They do, however, provide a solid basis to expect positive surprises in due course. The fact that the mood concerning the eurozone economy is now so gloomy only makes me more convinced that the eurozone economy will beat expectations in the quarters ahead.

Why Draghi didn’t commit to QE

We have to look at the ECB’s action against this background. Draghi had, perhaps, spoken a little loosely on earlier occasions and raised expectations of aggressive further easing. Although he announced asset purchases last week, markets had expected more. Particularly, markets had expected the President to announce purchases of government bonds or signal that these were likely at some point in the future. He failed to deliver. But I think there are good reasons for this. First, I think the ECB does not need to become much more aggressive than they already are, including the announced asset purchases. As argued above, give it a little time and you will see that the economy is gaining momentum. Second, it is unclear what the purchases of government bonds would actually do. Some would argue that such purchases worked wonders in the US and the UK. That may be true (or not. Academics are divided about the effects of QE in the US.) We must bear in mind that the starting position is different. When the Fed started QE in 2008, it was against the background of huge stress in financial markets. The Fed managed to ease the stress and reduce volatility. The situation in European financial markets is clearly completely different now. A third consideration is the differences in views about this instrument in various European countries. It is easy to hit the Germans on the head for their opposition, but that opposition is real and Germany remains the largest economy in Europe. Large-scale purchases of government bonds by the ECB would undoubtedly lead to more divisions within Europe. And imagine what it might do to the political landscape in Germany. The anti-euro Alternative für Deutschland did not exceed the 5% hurdle rate in the European elections, but has won around 10% of the vote in more recent regional elections. In my opinion it is simply not worth alienating Germany over this.

Emerging economies

Perhaps I am biased, but I have more concern over emerging economies than over the eurozone. Growth in the emerging world has disappointed and I think there are reasons to believe that growth will only pick up modestly in the medium-term. The various regions each have their own challenges. In Asia, China’s performance is key. After a few years of growth in excess of 10% prior to the crisis, growth has come down and the authorities are now targeting 7.5%. In fact, even 7.5% is very high. While many think back to the years when growth exceeded 10%, those years were exceptional. The average of the last 20 years is 9%, so the current target is not far below that average. As time passes and the economy becomes even larger and the standard of living rises, it will become increasingly difficult to achieve growth rates far above those in other countries. Therefore, growth is bound to drop further in years to come, though the timing is uncertain. In addition to the inevitable longer-term slowing of the Chinese economy, the leadership is trying to deal with a number of problems: corruption, the alleged housing bubble and the shadow banking system. It is wise to address these issues, but the short-term effect on economic growth is negative.

Central and Eastern Europe is obviously feeling the effects of the Ukraine conflict. And Latin America has three challenges in my view. First, commodity prices are not favourable to them. Between 2002 and 2008 commodity prices more than doubled, providing a huge tailwind to many Latin American economies. Commodity prices then dropped sharply during the crisis, but almost doubled again over the two-year period starting early 2009. Since 2011, however, commodity prices have drifted lower. A tailwind has, thus, turned into a headwind. A second problem is that Latin American governments could have used the tailwind of rising commodity prices better to reform their economies. Bureaucracy, rigidities and a high cost base in some countries are now preventing a more dynamic development. Last, the elections in Brazil may have led to a wait-and-see attitude among companies. Hopefully, corporate investment will pick up once the second round of the presidential elections is out of the way later this month.

If we are right thinking that developed economies will see a pick-up in growth in the quarters ahead, emerging economies will benefit, but we do not expect more than a modest gain in growth momentum.