EU: Can Economic Strength Cure Political Fragility?

Transcription

1 MACRO REPORT EU: Can Economic Strength Cure Political Fragility? April 2017 Andrea Brasili Senior Economist Global Asset Allocation Research Edited By Giovanni Liccardo Financial Communication Specialist Claudia Bertino Head of Financial Communication The Eurozone economic picture has started to improve. Key Insights The Eurozone recovery is progressing, although some risks remain tilted to the downside. There are signs of a self-sustaining growth engine at work, but the underlying inflation trends are still subdued. The ECB will likely maintain its accomodative stance as planned. The final round of the French election is approaching; it is an important event but far from being the only political event on the horizon: German elections are in Autumn and there are a lot of other issues at stake within Europe, not to mention the 2018 elections in Italy. Politics are not going away. Regarding Italy, the lower level of interest rates has simplified many of the plans to adjust the country s high level of debt, but political will and market confidence will be key to success. Is a Stronger Economy Here to Stay? Macroeconomic data has generally been stronger than expected since the beginning of the year, painting a better picture of the Eurozone economy. But is this improvement likely to be sustainable? In a recent speech entitled "Monetary Policy and the Economic Recovery in the Euro Area", ECB President Draghi observes that "since mid-2014, the recovery has evolved from being fragile and uneven into a firming, broad-based upswing". Building on his insight, here we will try to add some of our own points of view. The improved resilience of the euro area economy highlighted by Draghi - can be explained primarily by two exogenous factors: the oil price collapse that has boosted consumers purchasing power; and the ECB's monetary policy, that has favoured a weaker currency, prompted credit easing conditions and favoured a convergence in borrowing costs across different countries in the Euro area. A typical post-crisis source of domestic demand fiscal policy has been absent, due to the the process of balance sheet repair by domestic governments. Also the support of external demand to the recovery has been only modest as reflected in the very slow growth in world trade during the past few years. 1

2 Apr/06 Mar/07 Feb/08 Jan/09 Dec/09 Nov/10 Oct/11 Sep/12 Aug/13 Jul/14 Jun/15 May/16 May-06 Jan-07 Sep-07 May-08 Jan-09 Sep-09 May-10 Jan-11 Sep-11 May-12 Jan-13 Sep-13 May-14 Jan-15 Sep-15 May-16 Jan-17 EU Macro Report Can Economic Strength Cure Political Fragility? April 2017 Figure 1: Manufacturing PMI Rose More Steeply than Service PMI Manufacturing PMI Service PMI Italy Germany France Eurozone Source: Pioneer Investments, Thomson Reuters. Data as of April 6, Italy France Germany Eurozone Rising consumption favours a virtuous circle of higher employment and higher labour income. As the economy progresses, new underlying growth forces are emerging, making the ECB more confident that this recovery can turn into a self-sustaining one. The first force is a virtuous circle triggered by stronger consumption growth, (supported in an early phase by lower oil prices and low lending rates), which is boosting employment growth; labour income is accelerating and is driving up households spending. The second characteristic of this recovery, as highlighted by Draghi, is that the increase in consumption has been accompanied by improvements in households balance-sheets. The movement of financial accounts in the Eurozone on the chart below (net lending, i.e. household income less spending as % GDP) show the robustness of households balancesheets, which we would expect to give consumers a buffer against subdued wage dynamics (especially in some peripheral countries) or against price increases which could erode part of the real income rise. The third underlying growth force is that the recovery is increasingly more broadbased (in terms of sectors and geography). In this context, we believe that an additional stimulus could come from the improvement in global trade which the improvements in manufacturing surveys, especially for exporting countries (Germany and Italy), seem to anticipate. We also see the broadening growth/convergence story benefitting from the progress of the "internal devaluation" process, which implies that peripheral, inefficient countries would need to experience a long period of lower than the average wages and prices to regain competitiveness. Spain has so far been the only country that has behaved in this way, but now Italy and, to a lesser extent (because less is needed) France are doing well. Again, maintaining positive consumption growth in the presence of a low movement in wages was enabled by zero inflation over the last year. And looking ahead on the prices side, despite the rise in headline inflation, data is clearly saying that core inflation (the most obvious measure of "underlying" inflation) is not on an upward path (in March it actually declined to 0.67% from 0.86%). 2

3 Q1 2009Q3 2010Q1 2010Q3 2011Q1 2011Q3 2012Q1 2012Q3 2013Q1 2013Q3 2014Q1 2014Q3 2015Q1 2015Q3 2016Q1 2016Q3 As % of GDP EU Macro Report Can Economic Strength Cure Political Fragility? April 2017 Figure 2: Household Sector Reduced its Leverage, Internal Devaluation is at Play Eurozone: Net Lending (+) / Borrowing(-) Labour Costs Business Economy 6.0% 4.0% 2.0% 0.0% -2.0% -4.0% -6.0% -8.0% Household Non Financial General Government Rest of the World Source: Pioneer Investments, Thomson Reuters. Data as of April 6, Germany France Spain Euro Area Italy In conclusion, we think Draghi is right in saying that the Eurozone still needs a continuation of monetary support in order to be sure things will become selfsustaining, but looking in isolation at the purely economic realm, things could also be a little better than the picture painted by the ECB. Anti-EU results over the next political election may interfere with a sustainable economic recovery. Policy and Politics: What to Expect From Elections and EU Action? After last year s unexpected results from Brexit and the Italian Referendum and given the dense upcoming political calendar, there are widespread fears that the political arena might negatively influence the economic realm. Is it fair? To illustrate this fear, the former Italian prime minister, Letta, explicitly asserted that if Le Pen wins the election in France the Euro is over. True? Not for certain, but clearly having a euro-sceptic leadership in one of the leading countries of the area would not bode well in terms of "finishing the work" in the construction of the Euro area. And everyone is clearly aware that the next crisis cannot be tackled without moving some of the sharing mechanisms forward, that have so far only been partly implemented (the banking union), sketched (a common investment spending plan) or just preliminarily suggested (the likelihood of counter-cyclical spending or a common unemployment insurance). Without entering into detail, (see French Elections First Round: Key Takeaways for our latest thoughts) polls have been more reassuring for France, signalling a quite wide margin of victory for Emmanuel Macron versus Marine Le Pen in the run-off. Polls are also reassuring for Germany where, even though Martin Shultz - the SPD s rising star - has lost some steam, the consensus for the right-wing, anti-immigrant Alternative for Germany (AFD) is also losing ground. It is clear, however, that euro-sceptic forces remain present in Italy, where there is not one, but up to three anti-europe political parties, (admittedly these are at odds regarding a number of other items, but unite in blaming the Euro as the cause of strain for Italy) and the sum of their current, credited consensus amounts to around 45% of total votes. That said, there are also things that seem to be moving in the right direction: EU officials have managed to strike a deal (in principle) on a second review for Greece. Moreover, there were also discussions supporting investment, a common 3

4 EU Macro Report Can Economic Strength Cure Political Fragility? April 2017 unemployment insurance and a Eurozone-wide bad bank facility (on the lines suggested by the European Banking Association). Italy is showing signals to ensure debt sustainability in the long-term. Debt Sustainability in Italy Let s have a closer look at Italy, as we expect market focus will return here once the fear and noise surrounding the French elections is over (even more so if the outcome goes in a non market-friendly direction). The key question is that of debt sustainability and the will of the Italian government to be compliant with the prescriptions included in the fiscal compact. According to the Italian Minister of Economy and Finance, the 2016 deficit/gdp was at 2.4% with debt at 132.6% of GDP. The primary balance was at 1.4%, with cyclicallyadjusted estimates at 3%. The table below presents some of these numbers, plus the long-term ingredients for debt sustainability. Table 1: Italian Fiscal Data Deficit Primary Balance Interest exp CAPB Debt G20 Average r-g differential Age related expenditure Health Pension Source: Italian MEF, EU Commission, IMF. Data as of April 27, r-g (%) refers to the projected interest rate growth differential for the period As the table shows, from a long-term perspective Italy is well placed in terms of agerelated expenditure, which in 15 years time should be much lower than the average developed market. However, it is poorly placed in terms of interest rate growth differential over the next 5 years which, according to the last IMF estimates, is positive at 0.9% against a -0.9% average for developed markets. Moreover, it must be kept in mind that figures on interest expenditure in table 1 (which comes from the EU Commission) are likely to be a bit cautious. In fact, it is likely that the final bill for this year will be 3 to 4 basis points less than the 3.9% shown in the table and should remain on a downward path for some years despite recent increase in rates thanks to the lower the average maturity of Italian debt (ie a maturity 6.7 years currently yields less than 1.4%). The table below shows a simple non-stochastic exercise that illustrates different combinations of nominal growth, interest rates and primary surpluses for Italy. Table 2: Italian Debt Prospects Growth =3.2% Debt =2.4% Growth =2% Debt =2.4% Growth =3.2% Debt =3.4% Growth =2% Debt =3.4% Primary surplus to stabilize debt -1.00% 0.50% 0.30% 1.80% to satisfy debt rule 2.90% 4.00% 3.80% 5.00% to satisfy debt rule in 30years Source: Pioneer Investments. Data as of April 6, % 2.80% 2.60% 3.80% 4

5 EU Macro Report Can Economic Strength Cure Political Fragility? April 2017 The main point stemming from this exercise is that the decline of rates has bought a lot of adjustment time and has eased the burden of the adjustment itself. The first column of Table 2 shows the current situation: with a nominal growth rate of 3.2%, which seems attainable, and with a cost of debt at 2.4% (which is lower than current figures but corresponds to the yield currently paid by 10 years bonds); maintaining the current level of primary surplus would allow a convergence to the 60% debt-to- GDP target ratio in 30 years. For a quicker convergence, ie 20 years (as implied by the debt rule), the primary surplus should increase to 2.9%, which is nonetheless close to the current estimate of the cyclically-adjusted one. This seems to be a viable option. However, problems would arise if conditions worsen: if either nominal growth struggles or the cost of debt servicing rises considerably, the effort required will be much higher. ECB will maintain its accommodative stance, but the economic and financial stress situation has improved. In conclusion, Italy should be able to grow at a real rate of 1.1% + 2.1% deflator for 20 years, (in line with our forecasts for the next 2 years) and/or it should show that is willing to maintain the adjustment on an ongoing basis in order to avoid a rising interest bill. A nicely scheduled privatization plan could help in confirming the Italian government s intentions. The final combination in Table 2 shows a negative scenario in which the country fails to attain these objectives (and of course things could become worse than that in terms of cost of debt, as the sovereign crisis taught us): clearly Italy should do whatever it takes to avoid this. ECB: Not Amending Forward Guidance The ECB is currently implementing its monetary policy as indicated in its forward guidance: it will continue to purchase 60 billion of securities a month until the end of 2017, after that tapering is expected to wind down the QE purchases in The economic and "financial stress" situation has significantly improved in recent quarters, making exceptional monetary measures less needed than before, but overall easy financial conditions are still warranted since a significant part of the overall improvement must be accredited to the ECB s actions. The forward guidance, which stresses the fact that interest rates will be maintained at current or lower rates until well after asset purchases have been terminated, has been recently reaffirmed by the vast majority of ECB speakers, despite vocal calls for a different tune from the German, Dutch and Austrian members who favour a more rapid exit from monetary stimulus. The word "lower" in the guidance is, however, no longer strictly necessary in the present environment and will probably be dropped at coming meetings, with the market's expectations for this event currently centered on the June meeting. With monetary policy being defined for 2017 as a whole, market observers are trying to divine what will happen thereafter. Our best take at the present time is that Quantitative Easing will be run down to zero during 2018 and that the negative deposit rate will then be slowly raised towards zero in This outcome is, however, conditional to positive results for parties in the upcoming elections in the major European countries that are happy to continue to implement policies that have enabled the present economic recovery. A victory for the anti-establishment parties in France or Germany this year or in Italy next year would render this situation for more complex. 5

6 EU Macro Report Can Economic Strength Cure Political Fragility? April 2017 Important Information Unless otherwise stated, all information contained in this document is from Pioneer Investments and is as of April 26, The views expressed regarding market and economic trends are those of the author and not necessarily Pioneer Investments, and are subject to change at any time based on market and other conditions and there can be no assurances that countries, markets or sectors will perform as expected. These views should not be relied upon as investment advice, as securities recommendations, or as an indication of trading on behalf of any Pioneer Investments product. There is no guarantee that market forecasts discussed will be realized or that these trends will continue. Investments involve certain risks, including political and currency risks. Investment return and principal value may go down as well as up and could result in the loss of all capital invested. This material does not constitute an offer to buy or a solicitation to sell any units of any investment fund or any services. All investments involve risks. You should consider your financial needs, goals, and risk tolerance before making any investment decisions. Pioneer Investments is a trading name of the Pioneer Global Asset Management S.p.A. group of companies. Date of First Use: April 27, Follow us on: 6 REF-1163