Euro Macro: Falling profit margins generally followed by corporate caution – The ECB expects core inflation to rise over the next two years. The rationale rests very much on the behaviour of companies against the background of a squeeze in their profit margins. In explaining the projections, ECB staff economists note that ‘the moderate upward path of underlying inflation is expected to be supported by the expected pick-up in activity and the associated recovery in profit margins as past increases in labour costs feed into prices’. The idea is that companies will repair profit margins by raising their prices at a faster rate. So the question arises whether a profit squeeze is generally associated with rising inflation over time. History actually suggests the opposite. Looking at the three recent periods (before the current one) where the operating surplus of companies as a percent of GDP fell (1997 – 1999, 2008-2009 and 2011-2012) is instructive. In all three periods, core inflation started to fall by the end of the period of shrinking margins and that continued for some time afterwards. Indeed, corporates typically become cautious in these periods, and do not feel they are able to raise prices as they typically coincide with periods of weak demand. Instead, typically, corporate retrenchment follows, as companies try to repair margins by cutting costs. Slower job growth and slower wage growth tend to follow profit squeezes rather than rising inflation. The current period of shrinking profit margins has not ended yet. The profit share peaked in 2017Q3 and has been falling ever since. Indeed, in the second quarter of this year, it fell to the lowest level in the history of the series (it starts in 1995). So far during this period, core inflation has been moving sideways, though job growth and negotiated wage growth have peaked and have started to slow. These trends are largely in line with past experiences, and we would expect history to repeat itself given that the economy appears to be ending the year rather in stagnation mode. (Nick Kounis)
Euro Banks: German support for banking union still with strings attached – Over the weekend Olaf Scholz, the German finance minister, wrote a broad-ranging and detailed piece for the Financial Times, see here. In his article he announces his desire to push forward with EU integration, by pushing ahead with the banking union and the capital markets union. Scholz raised some thoughts on two major stumbling blocks for the banking union, a deposit guarantee scheme (EDIS) and sovereign bond holdings by banks. These stumbling blocks have slowed down European financial integration and his discussion piece from the eurozone’s largest nation reignites a credible desire to move forward with further integration in Europe. However, we would not jump to conclusions that his view can find a common ground in order to complete the banking union.
For example, Scholz’s vision is for a three-tiered deposit guarantee system, whereby the national deposit guarantee schemes would be firstly responsible until they were fully exhausted. Then, a European-wide system could provide assistance in ‘limited’ nature via loans. Then finally, the relevant member state could step-in if needed. The premise of a EU-wide deposit guarantee scheme was meant to alleviate national interest actions and his three-tiered approach does not fulfil this desire. However, Scholz’s attempt to create a discussion platform to bridge the gap between national responsibility and European strength is a positive start. Authorities could even soften their principles of the EDIS in order to provide some progress in addressing this heavily-delayed issue.
Scholz also addressed another key issue in the banking union debate, sovereign holdings by banks. Periphery banks within Europe often hold large amounts of their domestic sovereign bonds. For example, in 2018, Italian banks held just under EUR 400bn of Italian government bond debt (roughly 10% of their assets). The matter is magnified as European banks have the ability in certain circumstances to hold their sovereign debt at 0% risk-weight, regardless of the credit rating of the bonds. This leads to probably the most charged part of Scholz’s comment where he states that “sovereign bonds are not a risk-free investment and should not be treated as such”. Schloz’s view is heavily against previous views of governments in the periphery and could suffer significant pushback. Even if is view is softened by a hope of implementing a change over an unspecified “appropriate transition period”.
Scholz’s comments are positive for the future of banking as Europe strives forward in creating a banking union. Nonetheless, his thoughts could see opposition from other member states and shows the distance that still needs to be crossed to create a banking union at this stage. (Tom Kinmonth)
US Macro: The quiet softening in job openings – While not grabbing the headlines that the nonfarm payrolls reports do, the JOLTS job openings report is an important indicator of labour market health, and could provide an early signal for turns in the labour market. It is notable, then, that job openings have fallen significantly in the year-to-date, from a peak of 7.6mn in January to 7.0mn as of September, with year-on-year growth negative for four consecutive months. This is the biggest sustained fall (i.e. excluding unusual short periods of volatility in the data) since the last recession, with a consistent downtrend in place since the beginning of the year. It is also consistent with what the PMIs are telling us, with employment indices suggesting significantly lower demand for labour than earlier in the year. On the positive side, job openings still outnumber the unemployed (which total 5.9mn) – a highly unusual situation that did not occur in the last cycle. Labour markets are not therefore poised to fall off of a cliff, and as such, we do not expect a recession in the US. However, the direction is important, and the significant, sustained fall in openings points to a further drop in payrolls growth over the coming months – supporting our view of a slowdown in US growth in 2020. (Bill Diviney)