Eurozone Reflation - Core Issues

by: Lipper Alpha Insight

By Amareos

The initial market reaction to the ECB decision back in March to inject additional monetary policy stimulus was disappointing, to say the least, with the EUR exchange rate and regional bourses doing a very good impression of a yo-yo. However, European central bankers, not unlike their Japanese colleagues, faced with the same "perverse" initial market reaction, have argued that the effect of this monetary easing would appear over time and that a little patience was needed. So, how do things stand two months on?

At the eurozone level, the wait continues. Breakeven inflation rates in the eurozone remain below the ECB's target range, and as the chart below confirms, future inflation sentiment (orange line) has not only failed to rise, but has actually continued to move lower. Similarly, eurozone economic growth sentiment has remained stable at historically moderate levels (black line).

Exhibit 1: Eurozone Economic Growth and Inflation Sentiment

(Source: Amareos)

There is, in short, no discernible sign that the ECB's March easing has either directly generated the anticipated reflationary impulse or even had a boosting effect on private-sector expectations about future reflation. The absence of the latter effect is especially concerning given that the expectations channel of monetary policy should be one of the most responsive.

That said, while at the aggregate eurozone level the wait for signs of reflation is ongoing, the same is not true of some individual member states. There is evidence of reflation in the core, specifically Germany; something not readily apparent in the regularly watched economic data.

True, last Friday's GDP report showed German growth accelerated to 0.7% q/q in Q1, but this can hardly be attributed to the ECB easing in March. Moreover, the higher-frequency economic data suggest a loss of growth momentum within the quarter. German industrial output fell 1.3% m/m in March - the worst monthly performance since August 2014. Similarly, the more timely composite PMI surveys continued to lose momentum, with April's reading easing to 53.6.

However, the sentiment data we track at Amareos clearly shows that German economic growth perceptions (black line) have been steadily rising since mid-March, albeit to levels that remain historically modest. What's more, and in marked contrast to the eurozone regional aggregate, sentiment towards future German inflation (orange line) has also improved markedly over the same time frame1.

Exhibit 2: German Economic Growth and Inflation Sentiment

(Source: Amareos)

While a cyclical upswing in the region's largest economy is no doubt viewed as a positive development by many, it is also a potential source of concern, albeit for reasons that may not be readily obvious.

Alongside the March industrial production report, German trade data were also released. It confirmed that the monthly surplus rose to a record high reflective of divergent trends between exports and imports; the former continued to rebound, while the latter stagnated. As a direct result of this, Germany's current account surplus2 increased to more than EUR 30 billion, perpetuating the trend of persistently high surpluses seen over recent years. Such large and, importantly, sustained German external surpluses are problematic3, as they are a source of intra-regional political tension.

For instance, German politicians have been increasingly vocal in their opposition to additional ECB stimulus4. However, as ECB President Draghi riposted in a recent speech5, part of the reason why eurozone interest rates have fallen to such low levels is a direct consequence of Germany's persistently high external surpluses.

This point can be neatly illustrated by the sectoral balance approach derived from the national income accounting identity that states:

Because this is an identity, it must hold at all times, and using this framework, it is possible to determine the source of the German's high current account surplus. The current account balance exactly matches net private sector savings and the government fiscal balance. Plotting these three series for Germany - see chart below - it is clear that the German current account surplus reflects the combination of very high domestic private sector saving rates and the government's reluctance to run budget deficits.

Exhibit 3: German Sector Balances (% GDP)

(Source: IMF WEO Database, author calculations)

And, to President Draghi's point, it is this excess of domestic saving that is contributing to driving down the rate of return on investment, and hence also interest rates, within the region6.

A sustained German external surplus is also problematic because it makes the consolidation/recovery dynamics in the eurozone current account deficit club7 more difficult. This is a valid point whether or not the German external surplus is recorded vis-à-vis other eurozone members or not - an insight many economic commentators fail to comprehend8.

To the extent that Germany's surplus is extra-EU, this contributes directly to the aggregate eurozone current account surplus, presently running around the 3% of nominal GDP mark. The consequence of this external surplus is that purely on a transactional (as opposed to speculative) basis there is a net positive demand for the EUR9. Hence, the EUR exchange rate is stronger - and hence, less internationally competitive - than would otherwise likely be the case if Germany (and hence, the eurozone region as a whole) were running a lower external surplus or outright deficit. Importantly, this applies to all member states, irrespective of their domestic situation, by virtue of their membership of the single currency area.

To the extent that Germany's trade/current account surplus is intra-EU, and given one country's surplus constitutes another's deficit, this implies that other less-price-competitive eurozone member states must be running an equivalent deficit - one that must also be financed via inflows in the capital account. Prior to the eurozone crisis, these capital inflows were from the private sector. Indeed, it was the drying up of these flows that triggered the crisis.

While some funnelling of public sector funds did occur in response (via the ESCB's Target 2 system) because outright fiscal transfers were - and still are - deemed unacceptable, political pressure was also brought to bear on the current account deficit countries to correct them via an innocuous sounding "internal devaluation". As already mentioned, by virtue of EMU membership, the option of currency devaluation is excluded, implying that the only way to regain competitiveness without much higher inflation in the surplus countries was via deflation - sizeable deflation, in many instances - and a huge compression in economic activity.

One potential solution would be a German government-backed investment programme, preferably focussed on infrastructure. This would have the effect of boosting German economic growth without generating much inflation, because such a programme would raise aggregate supply and aggregate demand. It would serve to lower Germany's external surplus via higher imports as well as easing the adjustment process in the euro current account deficit countries. Despite the obvious and numerous benefits - reiterated just this week by the IMF10 - the chances of its implementation appear limited. This reflects German reluctance to engage in fiscal stimulus - a bias made transparent by the addition of the balanced budget rule in the German constitution that came into effect this year11.

Absent such policy action, and without full fiscal (probably implying also political) union and the ability to make intra-regional fiscal transfers, a clear inflationary bias in the eurozone current account surplus countries must result. The only reason this has not yet occurred is because the ECB has consistently undershot its inflation target. However, persistently undershooting its target would constitute a mandate breach on the part of the ECB, and faced - justifiably - with increasing pressure from the current account deficit countries, there are strong incentives to continue injecting additional monetary stimulus irrespective of German concerns. As our sentiment indicators suggest, this is a process that appears to be in its infancy, but, for the reasons just outlined, is likely to persist.

Investors seeking to exploit core reflationary bias are naturally drawn to increasing exposure to German nominal financial assets, such as equities and/or real estate. This would at least explain why the DAX has managed to buck the generalized wilt in global equity market sentiment witnessed since the start of the month (see chart below).

Exhibit 4: Global Equity Market Sentiment (Change since May 1, 2106)

(Source: Amareos)

Finally, real estate investors can take heart from the fact that despite some concerns about a housing bubble in Germany12, real estate sentiment (commercial - orange line - or residential - black line) is a long way from the sort of levels typically associated with a market peak (see chart below).

Exhibit 5: German Real Estate Sentiment

(Source: Amareos)

*Sentiment Analytics are based on Thomson Reuters MarketPsych indices.

1) The Netherlands has witnessed a similar rise in economic growth sentiment since the ECB's last easing, whereas in Italy economic growth, sentiment is barely changed, and in France, it has actually fallen. (Charts available on request).

2) The current account is a broader measure of international transactions than the trade balance, the difference comprising investment income flows and net transfers.

3) It is also nonsensical economically. No country can run a persistent current account surplus - a point seemingly lost on Germany's ruling politicians - ad infinitum, as it would imply the accumulation of ever more net foreign assets until the country running the surplus would eventually end up owning all of the capital available in the world. Obviously, a preposterous notion.

4) See: Germany’s Schäuble: Time Is Near to End Central Banks' Easy-Money Policies, WSJ, April 9, 2016

5) See: Addressing the causes of low interest rates, ECB Eurosystem, May 2, 2016

6) Two concepts that are related but distinct, even though they are often used interchangeably.

7) A much nicer, and economically more accurate, phrase than the porcine mnemonic more frequently utilized.

8) Although not former Fed Chairman Ben Bernanke - see: Germany's trade surplus is a problem, Brookings Institution, April 3, 2015

9) Foreign importers of eurozone goods and services need to buy more EURs than eurozone importers of foreign goods.

10) See: IMF calls for 'more dynamic' German economy, FT, May 9, 2016

11) More precisely, the German federal government is not permitted to run a structural (i.e., adjusted for the business cycle) budget deficit of more than 0.35% of GDP.

12) See: Germany's Unreal Estate Market, Handelsblatt, March 4, 2016