Quarterly Investment Strategy
EUROPE: NO SIGN OF A CREDIT BINGE
In a nutshell:
- By supporting credit growth as well as the banks, rather than attempting to manipulate the currency, the latest ECB action safeguards the Eurozone recovery.
- European economic growth should remain mediocre – but still above potential – in 2016.
- Brexit-related fears add to an already long list of political and institutional risks for the Eurozone.
Turning to Europe, last quarter was marked by further innovative action by the ECB, the most symptomatic measure being a program that in some cases even pays banks to lend to the real economy (which is what the new series of targeted longer-term refinancing operations (TLTRO II) effectively amount to). While we do not expect this program to trigger a credit binge, we do see it as a means to ensure that bank loan growth stabilises in positive territory.
Up to now there had been a manifest contradiction between the ECB’s efforts to improve the mechanisms of monetary transmission to the real economy and the pressure that its negative interest rate policy was imposing on banks’ profitability. Indeed, to date, one consequence of negative rates has been the flattening of yield curves, as the very need to resort to such a policy signals bleak growth prospects, exerting downward pressures on the long end of the curve, while the short-end has little room to fall.
This penalizes banks’ profitability, since they “borrow short” and “lend long”. Worse, to the extent that banks do not impose negative rates on deposits, they continue to borrow at zero, meaning that effective yield curves are even flatter than they appear.
In this context, banks can elect either to lend less (it not being profitable enough) or to increase lending rates (to restore margins), thereby tightening credit conditions for the real economy – and turning negative interest rates into a potentially deflationary policy.
The ECB has now understood the need to reconfigure its monetary policy so as to better support Eurozone banks, particularly those in the periphery. By attempting to facilitate domestic credit rather than manipulate the currency, the ECB is responding to a core issue for the Eurozone.
As the year progresses, we expect European growth to remain mediocre but not turn down – with a stabilisation of external trade flows and positive bank lending growth being of crucial importance. GDP growth of 1.5% would seem to be the best that can be expected for the Eurozone in 2016. Still, anything above 1% exceeds potential (which we estimate at 0.8%) allowing for an improvement in employment and a stabilisation of prices.
The main risks remain political as terrorist attacks serve to boost the popularity of right-wing parties, already riding on the coattails of public concern related to the migrant crisis. To the long list of political and institutional uncertainties must of course be added the pending Brexit referendum.
Fears of a Brexit are legitimate
On June 23, the United Kingdom (UK) will hold an historic referendum on whether or not to remain part of the European Union (EU). With polls indicating a close outcome, and although Switzerland is proof that life is possible outside the EU, investor concerns about the consequences of a Brexit are legitimate given not only the extended period of uncertainty that would follow such a vote, but also poor UK economic fundamentals.
With a near 5% current account deficit, the country is disturbingly dependent on external financing. Worse, this shortfall is mainly funded by volatile portfolio flows, which would likely bear the brunt of a Brexit. In addition, real estate and financial services currently account for some 20% of the UK economy. Massively overvalued, the former would be hard hit by a foreign capital flight while the latter’s access to the EU market would undoubtedly become more expensive. Finally, the competitive trade advantage stemming from a weaker currency could well be offset by the introduction of customs duties on UK exports to the EU.
The EU would not come out unscathed from a Brexit, to the extent that it could question its political stability and weaken its banking system, at a time when the economic recovery is still shaky.
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