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Talking Economics - January 2015
Investors have welcomed the ECB’s plan to launch QE. While we see this benefiting the eurozone economy, primarily through a weaker euro, there are a number of other effects to be aware of.
3 February 2015
- While the European Central Bank’s (ECB) quantitative easing (QE) programme will benefit the eurozone economy, it will also create shortages of low risk assets in the region and increase the burden on savers through its effect on interest rates.
- Markets are gloomy about global growth but we believe the benefits from lower energy prices and inflation (via real incomes and consumer spending) will offset the negative effect on the energy sector.
- In Europe, neither QE nor softer loan conditions for Greece (if the newly elected far-left Syriza are successful in fulfilling their promise to end austerity and ease bailout conditions) will fix the underlying problems both face. Greece and the eurozone need structural reforms, otherwise, they risk taking the same path as Japan.
- China’s slowdown has prompted hopes of stimulus and optimism for commodities but this is misplaced. The nature of the slowdown and the rebalancing of growth mean we are likely to see less of a lift than in the past.
Global 1: Careful what you wish for…
Investors have welcomed the ECB’s plan to launch QE. While we see this benefiting the eurozone economy, primarily through a weaker euro, there are a number of other effects to be aware of. Firstly, QE will exacerbate a shortage of low risk assets in the region as the ECB buys up all the stable, well-rated debt, creating a spill-over effect in international bond markets as yield-seeking investors are forced to look outside the region for investment opportunities. On the positive side, asset-starved investors may be more willing to fund public-private projects across Europe, which could be positive for growth. However, until then, the main effect of QE is likely to be to further increase the burden on savers as interest rates are likely to stay below inflation. Investors should be careful what they wish for.
Global 2: Low inflation is only half the story
The new year saw the International Monetary Fund (IMF) downgrade its 2015 global growth forecast to 3.5%, from 3.8% in October. Our own forecasts will be updated next month, but we are likely to take a more optimistic view, with a strong possibility of an upgrade to our growth projections, driven by the benefits we see accruing from the fall in the oil price. Economists have been quick to assess the effect of lower oil prices on inflation, but so far have failed to recognise the benefits to growth. Although the energy sector will be hit by lower capital expenditure and employment, it is important to remember that the role of the sector in the global recovery has been modest, for example, the energy sector has added 270k jobs since the economy turned in 2009 compared with a 9.15 million total. Consequently, we expect these adverse effects to be offset by the benefits to the non-energy sector of lower energy costs and higher consumer spending. This should result in stronger global growth and lower inflation.
As ECB begins QE, Greece votes for austerity to end
ECB takes leap of faith
The ECB’s QE programme that was announced in January will benefit the eurozone economy by reducing the risk of deflation. However, the purchase quotas may be difficult to fill given two important factors: the ECB can only buy 25% of any individual bond issue and can only make purchases in proportion to the individual country’s subscription to the ECB’s capital base. These factors will limit the number of bonds available to the ECB and if the ECB were to deem the scale of purchases to be insufficient to boost growth, it would seriously struggle to expand its programme any further. Furthermore, the ECB will potentially be buying more than three times the issuance of new government bonds between March 2015 and September 2016. This can certainly push bond yields in Europe to fall further, which in turn lowers interest rates offered by banks to the real economy. This is useful but we feel that the main impact will come through from the weaker euro, which will make European exporters more competitive internationally.
It is important to note that QE is not a panacea for the monetary union’s ills; for this, deep structural reforms are required. Ironically, QE will reduce the incentive for governments to implement these as it introduces a distortion to bond markets and removes the discipline that comes from market pricing based on fundamentals. Without reforms, the ECB may be forced to add additional stimulus as growth falters again, which in turn reduces incentives further. Could this be the downward spiral that leads Europe down Japan’s path?
Greek backlash against austerity
In our view, the results of Greece’s elections, which saw the far-left Syriza party win the most votes and parliamentary seats, are a setback but not necessarily a disaster. Yet another leader promising hope and a rollback of austerity has been elected, but he will probably fail. President Hollande in France is just one example of such false hope.
Where now for Greece?
As we see it, the situation in Greece can play out in one of a few scenarios:
- Benign outcome. Syriza wins some concessions from the Troika* in exchange for continuing with reforms. The economy slows but avoids a recession and the impact on wider Europe is insignificant.
- Syriza fails. Syriza fails in its Troika negotiations and is unable to deliver its promised fiscal changes. The coalition breaks down and the economy slows but the wider implications are insignificant.
- Grexit. Syriza fails to reach a compromise with the Toika and refuses to pay interest on Troika debt. Europe halts ECB liquidity funding to Greek banks, leading to bank runs. Eventually, Greece is forced to leave the currency union. The Greek economy suffers a deep and prolonged recession, with negative spillovers in Europe.
- Troika out, but no Grexit. Troika negotiations end in stalemate with no further credit provision. Greece continues to service its loans, but has to run a larger surplus. Greek banks remain supported by the ECB so Greece stays in the eurozone. The added austerity causes a recession but spillover effects are temporary and small.
Greece's future now depends on whether Syriza can govern in a responsible way, and recognise that major structural reforms are still needed. Unfortunately, it is hard to find optimism on this front given Syriza rhetoric. Meanwhile, Greece’s membership of the EU depends not only on structural reforms, but also on Alexis Tsipras’s ability to reach an acceptable compromise with the Troika. We are almost certainly going to see a standoff in negotiations in the near-term. The risk of ‘Grexit’ is once again elevated and investors should think very carefully before investing in Greece.
Is bad news in China good news for commodities?
China’s economy expanded 7.4% in 2014, missing the government’s 7.5% target and while most people expect further government stimulus in 2015, less unanimous is what the market impact of any stimulus might be on commodities. While we don’t see agricultural commodities as being much affected because demand is driven by population growth rather than economic growth, there is some evidence that metals prices should benefit. This is largely because the government’s new stimulus is set to take the form of infrastructure investment and some monetary easing. Research suggests that there is a lagged effect from infrastructure on metals prices although, in fact, real estate investment is much more commodity intensive. The government’s infrastructure spending plans should therefore provide some support to metals demand and prices, although this is likely to be offset by continued weakness in property investment as the property market slowdown persists in 2015.
Looking at the effect of monetary easing, we see that an expansion of money supply seems to be associated with strong metals prices as it boosts the supply of credit for investment. However, it is apparent that the relationship between money supply growth and property investment has broken down over the course of last year as a slowing property market and falling land values has seen declines in both demand and supply of credit in the sector. So we do not, therefore, expect monetary easing to have much impact on infrastructure investment or commodity prices.
It is also worth pointing out that it is extremely unlikely that Chinese stimulus would provide a boost to oil, particularly given that the role of oil in Chinese growth has been declining steadily since at least the 1980s, displaying no relationship with the investment cycle.
A China-driven renaissance for commodities, based on current stimulus plans, is not in the offing.
*ECB, IMF and European Commission
Talking Economics is based on Schroders Economic and Strategy viewpoint, produced by the Schroders Economics Team: Keith Wade, Chief Economist, Azad Zangana, European Economist, and Craig Botham, Emerging Markets Economist.
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