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Macro: crisis redux for the eurozone?
Quarterly Outlook
Summary: Every day, we get asked, about “‘Recession or no recession?’”. It is not a binary trade situation where recession is bad, and no recession is a green light for risk.
Every day, we get asked, ‘Recession or no recession?’ It is not a binary situation where recession is bad and no recession is a green light for risk. We are going to be in much lower growth, especially in 2023, than many had expected, whether there’s technically a recession or not. The material growth slowdown is visible in all the recent statistics. The eurozone is certainly in a worse position than the United States or China. Eurozone policymakers, especially the dovish majority of the European Central Bank (ECB) Governing Council, took too long to acknowledge that inflation is not as transitory as earlier thought. I remember the short but instructive discussion I had with the central bank governor of a ‘small’ eurozone country in October 2021. At that time, we been warning our clients for months that high inflation is here to stay. This wise governor agreed that there was growing evidence that inflation won’t disappear, and that the central scenario of the ECB staff was too optimistic. But he belongs to a minority in the Council and had little leverage to push the rest of the Council in the right direction. Several months later, I think there is now a broad consensus that inflation will remain a headache for years to come.
Let’s look at commodities. Despite all the communication around green transition, Europe is still very dependent on fossil fuels (oil, natural gas and coal). Because of the war in Ukraine, we are shocking the Russian supply of fossil fuel—the very thing we use. With demand rising and supply shocked, prices rise—this is basic economics. We would logically expect investment to jump to crush prices. But there are two issues. First, we don’t consume crude oil but rather the refined part of it. There is an entire infrastructure built to refine Russian oil in Europe, but we cannot use it anymore. We need to replace it, but it will take years to build an entire new infrastructure. In the meantime, costs will continue to increase. Second, the European Union is imposing regulations for the green transition from fossil fuel. Europe has always acted by regulating things. But green transition regulation has diverted needed investment in fossil fuel infrastructures to renewable energy, without making sure that green energy can provide a constant supply of energy to Europeans. At the end of the day, this means higher energy costs for years to come. Inflation is structural.
However, there is another factor which is inflationary to some extent—fiscal policy. European governments have unveiled emergency measures to address inflation—for instance, value-added tax (VAT) reduction on energy and extension of the benefit of the ‘social tariff’ on electricity and natural gas for the poorest households in Belgium, and increasing the minimum wage to €12 per hour from next October and an additional aid of €100 for the poorest households in Germany. With the fiscal potential in Europe far greater than many other places, expect these one-shot measures to become more permanent and for other subsidies to come soon.
Inflation is structural
The main issue is inflation on the supply side. This refers to inputs to production (labour, fuels, commodities like agriculture and electricity), operations and transport. Operations can be shocked and resumed quite fast. We experienced it in Europe during the pandemic. Transport can be shocked due to a strike, blockages or a lack of containers (which is a major issue nowadays) too. But this can be resolved with time. We expect the arrival of new containers from 2023 onwards will help ease transportation bottlenecks. All of these can be considered as transitory. But the supply shock affecting inputs to production is certainly much more permanent.Let’s look at commodities. Despite all the communication around green transition, Europe is still very dependent on fossil fuels (oil, natural gas and coal). Because of the war in Ukraine, we are shocking the Russian supply of fossil fuel—the very thing we use. With demand rising and supply shocked, prices rise—this is basic economics. We would logically expect investment to jump to crush prices. But there are two issues. First, we don’t consume crude oil but rather the refined part of it. There is an entire infrastructure built to refine Russian oil in Europe, but we cannot use it anymore. We need to replace it, but it will take years to build an entire new infrastructure. In the meantime, costs will continue to increase. Second, the European Union is imposing regulations for the green transition from fossil fuel. Europe has always acted by regulating things. But green transition regulation has diverted needed investment in fossil fuel infrastructures to renewable energy, without making sure that green energy can provide a constant supply of energy to Europeans. At the end of the day, this means higher energy costs for years to come. Inflation is structural.
However, there is another factor which is inflationary to some extent—fiscal policy. European governments have unveiled emergency measures to address inflation—for instance, value-added tax (VAT) reduction on energy and extension of the benefit of the ‘social tariff’ on electricity and natural gas for the poorest households in Belgium, and increasing the minimum wage to €12 per hour from next October and an additional aid of €100 for the poorest households in Germany. With the fiscal potential in Europe far greater than many other places, expect these one-shot measures to become more permanent and for other subsidies to come soon.
When risk becomes reality
Economic history has taught us that the only way to lower inflation is to hike interest rates. Many other central banks have done it since the exit of the last global lockdown in spring 2021. After a long period of hesitation, the ECB is finally going with the crowd. They will hike interest rates at the July meeting by 25 basis points (a ‘gradual’ tightening)—the first since 2011. It would be too easy if the ECB could normalise monetary policy by only focusing on inflation and growth. However, there is another issue to tackle that’s as important as high inflation—financial fragmentation.Bond market volatility is picking up everywhere, mostly due to the big global inflation shock that is hitting everyone. But the deterioration is faster in the eurozone. The repricing of risk in a world without quantitative easing (QE) is painful. The ECB Systemic Risk Indicator (developed in 2012 and based on 15 financial stress measures) is back to levels not seen since the outbreak in March 2020 (see chart 1). The repricing is more painful for some countries than others. Since the end of QE, Italy’s borrowing costs have jumped higher. The 10-year bond yield is now nearly three times as high as in early February. The spread vis-à-vis Germany has risen too and is back in risk territory (see chart 2). What is most worrying is not the level of bond yields but the process. Volatility is picking up too quickly and liquidity conditions are deteriorating fast at the same time. Basically, foreigners just want to get out of the Italian bond market (see chart 3).
There is no doubt the ECB will announce a new tool to manage sovereign spreads soon, perhaps as early as the July meeting. We don’t have many details at the moment. Based on Isabel Schnabel’s recent comments, we can assume it will be some kind of Outright Monetary Transactions programme with light conditionality, for a temporary period of time and with shorter maturities than the Pandemic Emergency Purchase Programme (perhaps between two to five years). It should be enough to avoid a repeat of the 2012 crisis, but this is far from certain. The ECB cannot refrain from raising interest rates. The more they do, the more that breaks and the more they will have to buy eurozone government bonds. From an optimistic viewpoint, a eurozone crisis redux is not all negative. From 2012 onwards, the previous crisis helped to bring about crucial institutional reforms that strengthened the eurozone framework. The same could happen again in case of a new crisis. However, the eurozone bond market situation raises a serious question in the long run: Can this go on forever ? At some point, the southern eurozone countries should be able to face the markets without the ECB stretching its mandate to rescue them. Otherwise, the ECB could end up owing the entire Italian debt.