Market Bulletin - Negative money
The European Central Bank took significant remedial action on Thursday, but markets ended the week little changed.
At some point, even the best magician runs out of tricks. In their quest to spur growth and inflation, central bankers in some of the world’s more sluggish economies have been turning in recent months to untried techniques and extreme measures. Thus almost a quarter of global GDP is now generated by currency regions with negative bank rates. While many investors appreciate these short-term boosts, markets are increasingly nervous that central bankers will finally exhaust their repertoire.
Last week, however, Mario Draghi made it clear that the European Central Bank (ECB) still has ideas up its sleeve. In a press conference on Thursday, the ECB chair announced three important measures: a cut in the interest rate from -0.3% to -0.4%; a heavy-duty extension of quantitative easing (QE) from €60 to €80 billion a month; and a raft of refinancing arrangements for banks willing to lend to the real economy.
“This package goes way beyond anyone’s expectations,” said Stuart Mitchell of S. W. Mitchell Capital.
The rate cut was an important step further into negative territory, but the QE extension marked a more significant change of pace (which is presumably why the German and Dutch ECB committee members voted against the package). Yields on sovereign debt in peripheral Europe dipped on the news. So too did yields on European corporate debt, after the ECB said the asset class would be included in its bond-purchase programme for the first time.
Not everyone welcomed the negative rate announcement. On Wednesday, senior European bankers expressed their concerns to the ECB, arguing that, because they could not pass negative rates on to customers, they had to take great risks with clients’ deposits. Bank profitability is hardly top priority for the ECB, but the purpose of the package is to offer more reasons to lend and spend – not fewer. Thus the third element of the March package was the promise of targeted longer-term refinancing operations (LTROs), through which the ECB will extend affordable funding to the banking sector.
An initial stocks surge suggested Draghi’s star was rising once more, yet his comment that the ECB anticipates no more rate cuts helped end the surge: the FTSEurofirst ended the week up by only 0.21%.
“The equity market reaction [to the ECB decision] has so far been negative – the magnitude of the package coupled with a downward revision in growth forecasts has unsettled many,” said Stuart Mitchell. “We are somewhat more positive. Underlying inflation remains pretty stable and the economy continues to recover very nicely across the region. The LTROs should help ease the negative impact of lower deposit rates and help bring some confidence back to the banking system.”
Across the eurozone more broadly, indicators were discouraging: among them meagre eurozone GDP growth figures, a cut to ECB growth and inflation forecasts, and France’s biggest dip in factory sentiment since 2013. The Irish economy was a bright spot; it achieved 2015 growth of 7.8%.
Not long ago, China was significantly exceeding even that figure; but the mood is subdued at this year’s National People’s Congress (NPC) in Beijing. (The NPC will in effect approve a five-year plan drafted by the Communist Party of China.) Last week, figures showed Chinese exports falling 25% in February (annualised).
“Exports were very strong in February last year – up nearly 50% – because the Lunar New Year started late… [and] disruption… was pushed into March,” said Julian Evans-Pritchard at Capital Economics. “So there is a big seasonal effect and we will probably see a significant reversal.”
Markets have also worried that capital flows out of China in 2015 and 2016 reflect fundamental problems in the Chinese economy. Last week, however, a report by the Bank for International Settlements suggested that currency outflows from China had in fact been driven by the carry trade (which seeks to profit from currency fluctuations) rather than by sagging confidence among Chinese savers. Moreover, February outflows were less than a third the size of those in December or January.
Worries about Chinese growth often translate into global concerns. Last week the IMF warned it might downgrade its 2016 global growth forecast. (It said China’s corporate and financial sectors – and growth rate – were all problematic.) Nevertheless, reports by Capital Economics and the Peterson Institute of International Economics said that markets had been wrong to point to a global recession.
While the Nikkei 225 dropped 0.45%, the S&P 500 ended the week up 0.84%, above its 2016 opening. Last week Stanley Fischer, vice chairman of the US Federal Reserve, said the US may now be seeing “the first stirrings of an increase in the inflation rate” – if so, it would be welcomed.
Inflation is always sensitive to commodity prices but, since 2014, the extent of their price declines has relegated other inflation factors to footnotes. Signs of a commodity revival continue; Brent crude ended the week above $40. But a Goldman Sachs report said the commodity rout was not over: prices of oil, iron ore, aluminium and copper will fall again. Moreover, Bank of America Merrill Lynch said that, even if China reassigns 500,000 steel jobs as planned, steel oversupply will persist. Cheap commodities have kept inflation far below central bank targets.
The FTSE 100, the most commodities-sensitive of the main indices, ended the week down 0.96%. Figures released last week showed UK manufacturing and the trade deficit both headed in the right direction (though only marginally), but the goods trade deficit with the EU increased. Mark Carney, governor of the Bank of England, warned that a British EU exit was “the biggest domestic risk to financial stability”.
On Wednesday this week, the UK Chancellor will present the Budget. The size of the build-up is expected to stand in stark contrast to the scale of the reforms George Osborne will finally announce. After months of talk about historic reforms to UK pensions, this year’s Budget is now expected to leave the biggest pension reform (to tax relief on contributions) for later.
Now that the headline reform appears to be off the table (in the short term), the Chancellor may turn his attention to salary sacrifice pension contributions. Used by most UK companies, the scheme costs the Treasury several billion pounds a year, making it a very appealing reform target for George Osborne, who faces a rising level of public debt. The Chancellor said on Friday that the UK economy is £18 billion smaller than previously thought, as earnings and inflation have underperformed. He therefore wants to achieve £4 billion in spending cuts in the Budget, according to press reports.
By way of recompense, Osborne may choose to fulfil an election pledge and raise the higher rate tax threshold. Indeed, ‘election’ may yet prove an important word when it comes to the Chancellor’s reform timetable. While some reforms are expected to be postponed due to the referendum, George Osborne is likely to want to stick to his broader promise to achieve a budget surplus in 2020 – not simply because it’s the end of the parliamentary term, but also because it is when his boss has promised to vacate the top job.
S. W. Mitchell Capital is a fund manager for St. James’s Place.
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