Webcast 033 | Losing interest: why negative interest rates present a challenge to global growth

It has been a tough start to 2015: what will be the outcome of persistently low interest rates be? Rebecca Harding and Sarasin & Partners’ Subitha Subramaniam discuss the topic.

 

Webcast 033 Author  |  Rebecca Harding  |  CEO

Webcast 031 | QE, Central Banks and Europe’s Future

As the ECB’s Quantitative Easing programme gets underway in an attempt to reflate the eurozone, questions remain over how effective it will be. Rebecca Harding and Shaun Richards discuss.

 

Webcast 031 Author  |  Rebecca Harding  |  CEO

Webcast 030 | Lessons from QE in four charts

March 2015 marks the start of Quantitative Easing (QE) in Europe. Given broader uncertainty around the effectiveness of QE, what lessons can the ECB learn from QE in the US, Japan, and the UK?

 

 

Webcast 030 Author  |  Rebecca Harding  |  CEO

Trade Insight February 2015

Currency wars and volatility

 

Executive summary

  • January 2015 was a volatile month with markets unsettled by the uncertainty generated at the beginning of the month over European Central Bank Quantitative Easing (QE). This uncertainty was compounded by the removal of the Swiss franc’s currency peg to the euro by the Swiss National Bank.
  • Both events have put significant pressure on the euro during the first month of 2015 which Delta Economics expects to continue throughout the year. We are forecasting that the euro and US dollar may well reach parity by the end of the year, if not earlier if current trends continue.
  • Delta Economics is expecting the PMIs published at the beginning of February to be broadly in line with consensus expectations. We expect China’s PMI to fall back while we are expecting PMIs in Europe to improve slightly. It is too soon to herald a recovery but this is a positive start to 2015.
  • The Delta Economics Asset Trade Corridor Index (TCI-A) reflects the underlying volatility in markets with Information Ratios largely negative for equities and currencies. The TCI-A has produced an average monthly paper return of 1.3% over the past 19 months. The average return on an equally weighted portfolio in January 2015 was 2.2%.
  • We expect oil prices and the value of the euro to fall during February. We expect other commodity prices to rise (against consensus), equities to rise and the US dollar to strengthen against most major Emerging Market currencies. However, the tightest strategy that we use suggests a strong downside risk to all these calls because of the underlying volatility reflected in the information ratios.

 


Greeks bearing gifts? The consequence of January for the euro in 2015

 

Delta Economics is of the view that the euro will reach parity with the US dollar by 2015 and has the potential to fall lower if current volatility and pressures on the currency continues. This is for several reasons:

First, Delta Economics considers the euro to have been over-valued for some time, largely as a result of the German trade surplus. Although Europe needs German trade to be strong because of the supply chains that originate in Germany and spread out across Europe, the high value of the euro has made it harder for the internal imbalances of the eurozone to be corrected by export-led growth outside of Germany.

At the outset, markets viewed the eurozone with a degree of scepticism. By June 2001 one euro bought 0.85 US dollars. As time has gone by, eurozone performance has, inevitably perhaps, become more dominated by Germany pushing the value of the euro up and kicking the issues of intrinsic imbalances between Member States down the road. However, instead of resolving imbalances by everyone “becoming more like Germany”, a weaker currency simply reflects the fact that everyone isn’t like Germany.

Second, the fact that QE was necessary in the first place made it abundantly clear that the eurozone is far from a marriage of equals. The euro came under pressure ahead of the announcement and fell to new lows subsequently. But it is here where the facts start to conflict with policy expectations. Theoretically, a lower euro should boost the real economy through trade because exports should become cheaper. However, what we’ve actually seen over the years since the introduction of the euro is a high correlation between the euro’s value and the value of trade: in other words, when the euro goes up, so does trade (Figure 1).

We believe there are two explanations for this: in the first instance, European trade, dominated as it is by Germany France, Italy, the Netherlands and Belgium, is largely at the high end of supply and value chains and therefore does not respond particularly to changes in the value of the currency. Even for weaker nations more dependent on commodities, the importance of Europe-wide supply chains means that the relationship still holds. For example, the correlation of the value of the euro with Greek trade is 0.89.

Furthermore, the value of the euro is actually a signal by the markets about the strength of the European economy: when the economy and institutions seem strong, the value is high and vice versa. In other words, as discussed previously, trade is an important driver of the value of the euro because of its importance as a driver of economic performance in the eurozone generally. While trade is falling, and we are forecasting it will fall by 3.7% within the eurozone in 2015, so too can we expect the value of the euro to fall. The result is that policy can have very little effect on the real economy through currency manipulation.

 

2015-02-03_backToReality_fig01_v01

 

Figure 1  |  Monthly value of eurozone exports, USDbn versus USD per euro spot, Last Price Monthly, June 2001-Dec 2015
Source  |  DeltaMetrics 2015, Bloomberg

 

The third reason why the value of the euro is likely to come under increased pressure is the outcome of the Greek election in January. Syriza is looking to renegotiate its debt and start the process of loosening the tight controls it has had over spending. It will not be helped by a lower-valued euro (Figure 2) because of its inter-dependency with trade in the eurozone as a whole through its role as a trade hub.

 

2015-02-03_backToReality_fig02_v01

 

Figure 2  |  Monthly value of Greek total trade (USDm) versus USD per euro spot price, Last Price Monthly, June 2001-Dec 2015
Source  |  DeltaMetrics 2015, Bloomberg

 

Greece’s trade to GDP ratio is 0.4: in other words, there is a fairly strong pull of trade on Greece’s GDP. Oil is a critical part of this; the correlation between Greece’s trade and the oil price is 0.80 – largely because of the importance of oil in Greece’s total trade structure. Greece’s exports of refined oil, for example, are twice as high as the second-largest export sector – medicines.

 

  2015-02-04_tradeInsight_fig03_v01

 

Figure 3  |  Greece’s debt and the challenge of trade
Source  |  DeltaMetrics 2015

 

Greece’s trade is just 0.4% of Europe’s total trade; however, their trade is nevertheless important both because of the impact that it has on the prospective growth of the Greek economy and as a portent for the negotiations about debt restructuring, austerity and structural reform ahead. Put simply, if a low-valued euro is unlikely to help boost Greek (or eurozone for that matter) trade more generally, then there is little that monetary policy at a European level can do to help long-term growth in the peripheral nations. Greece’s debt is, according to Syriza, not repayable and imposes too many restrictions on the Greek economy. One option is to set debt repayments against growth targets but, given falling oil prices and falling intra-European trade, this looks ambitious.

The eurozone needs more than QE and a low value of the currency for growth. The eurozone’s peripheral nations’ struggle for growth is accentuated by the fact that they must trade in euros internally and externally. Given “austerity” constraints attached to their sovereign debt, this makes it very difficult to grow. There will continue to be sustained political dissent between Member States on the best way to resolve the issue of Greece, and there is a danger that the debate will spill over to other nations, like Spain, Ireland and Portugal.

The likely outcome of all of this is continued market pressure on the euro (Figure 4).

 

2015-02-03_backToReality_fig04_v01

 

Figure 4  |  Monthly value of Eurozone exports versus USD per Euro spot price and linear forecast, Jan 2014-May 2016
Source  |  DeltaMetrics 2015, Bloomberg, Delta Economics analysis

 

The pressure on the euro over the last year has mostly been downwards. The Delta Economics asset price forecasting model, which is itself based on country-sector-partner trade flows, is indicating short positions on the euro for most of 2015. Even if the trend continues in a linear way as it has done over the past 12 months, this suggests parity by the end of the year.

 


 

Outlook for PMIs February 2015

 

The Trade Corridor Indices (TCIs) measure the trade flows of any one country and forecasts these forward using its proprietorial forecasting methodology. Each index is specific to the country it relates to in that the trade corridors and flows will differ for each country. The rate of change in the index is correlated with the Purchasing Managers’ Index (PMI) for that country.

The TCIs are based on actual data and although they are highly correlated are in no sense an alternative to the PMIs since the methodologies differ. PMIs, being survey-based, are sentiment indicators while the TCIs give an actual and a forecast indication of how underlying trade conditions, including trade finance, are moving. In other words, the TCIs provide a predictable and quantifiable view of how changes in the global economy are affecting trade at an individual country level.

Generally we are expecting manufacturing PMIs to move in line with consensus this month with very little movement on their December values. The only exception is French services where we are expecting a bigger increase in the service sector PMI compared to consensus. However, although the accuracy of the predictions has been reasonable over the past 12 months, the correlation is substantially lower.

The predictions are based on:

  • The correlation of a country’s top 500 trade corridors with that country’s Manufacturing PMI to create a trade corridor index associated with the PMIs/sentiment (TCI-S)
  • Correlation of the rate of change in that index (6 month moving average) with the Manufacturing PMI
  • The monthly change in the six-month moving average (positive change suggests PMIs will improve while negative suggests they will deteriorate).

Outlook for PMIs February 2015  |  Outlook risk

  • The above information is based on the PMI tickers as listed.
  • The predictive capacity of the model is strong, but not perfect as they are based on correlations rather than causal relationships
  • Note – the correlations and values given are against the Tickers listed and not with the Flash PMIs although the Flash PMIs follow similar patterns
  • Note – forecast values are indicative of scale of change only and should not be seen as absolute values

 2015-02-04_tradeInsight_fig05_v01

 

Figure 5  |  PMI outlook, February 2015
Source  |  Delta Economics

 


 

Trade Corridor Index Asset Price Calls

 

Overview

The Delta Economics TCI-based asset management strategy takes the top 500 trade corridors (trade between two countries by sector) against and asset price. It creates an optimum corridor index of those trade corridors each month and has been tracking its performance over the past 19 months. This is a systematic model and assets are included in the portfolio if one of the following conditions is met:

  • The signal strength, which measures the percentage of trade corridors that are pointing to a long or short call: this must be higher than 95%
  • The signal strength is greater than 85% and the Information Ratio (which measures the performance of that optimum corridor relative to benchmark returns) is greater than 0.5 (indicating good or very good back-tested performance)
  • Where there is a signal strength of 100 and only one corridor in the index, the Information Ratio must be above 0.5.

The returns, which are not optimised and based purely on an equally weighted portfolio strategy, were 2.2% in December 2014. This means that over the past 19 months, returns have averaged 1.3% per month with above average returns in 11 months.

 

2015-02-04_homepageGraph_v01

 

Figure 6  |  TCI-A returns, June 2013-January 2015
Source  |  Delta Economics

 

The calls for February 2015 reflect underlying volatility in markets with Information Ratios largely negative or mildly positive. Although the TCI-As across a portfolio of assets produced a return of 0.7% in October, this was against a similar backdrop of low or negative Information Ratios, which arguably underpinned the correction in the middle of the month. Because of these low, even negative, IRs our portfolio suggestions potentially have substantial downside risk attached to them.

 


 

Commodities

 

The short call on oil reflects continuing downward pressure on oil prices despite the mild rally at the end of January 2015. While the signal strength is low, the information ratio is high suggesting that this is a strong call. Similarly, the long call on Gold has weak information ratio but strong signal strength suggesting that Gold may continue its upward path as a hedge against deflation. Because of underlying uncertainties in the global economy and the fragility of commodity markets, the long calls on copper and steel appear contrary to market sentiment currently. However, our trade outlook for the world in 2015 is mildly more positive than it was during 2014 and Asia in particular is forecast to grow strongly. A long call on copper and steel suggests prices may start to increase during February as a lead indicator of manufacturing activity increases towards the end of Q1 2015.

 

2015-02-04_tradeInsight_fig07_v01

 

Figure 7  |  Delta Economics TCI-A based strategy, commodity calls for February 2015
Source  |  Delta Economics analysis

 


 

Equities

 

We are expecting all equity markets to increase this month, but the signal strengths are weak and the Information Ratios largely negative. A long position arguably reflects the sustained flight to equities following European QE, but the negative information ratios reflect volatility and substantial downside risk.

 

2015-02-04_tradeInsight_fig08_v01

 

Figure 8  |  Delta Economics TCI-A based strategy, equity calls for February 2015
Source  |  Delta Economics analysis

 


 

 

Currencies

 

The calls generally suggest that the euro will continue its weaker path against the US dollar this month. The information ratio on this call is strong, but the signal strength relatively weak. Other emerging market currencies similarly paint a picture of a strengthening dollar as expectations of an increase in US interest rates later this year versus perceived weakness in Europe and Japan continue to stoke up its value.

 

2015-02-04_tradeInsight_fig09_v01

 

Figure 9  |  Delta Economics TCI-A based strategy, equity calls for February 2015
Source  |  Delta Economics analysis

 

 

Delta Economics Trade Insight February 2015  |  Author  |  Rebecca Harding  |  CEO Delta Economics


tradeInsight_TCI-BasedStrategy

Lessons from QE in four charts

Why nothing should be taken for granted  |  March 2015 marks the start of Quantitative Easing (QE) in Europe. The much anticipated programme will inject €1.1tn into the eurozone’s coffers up to September 2016 at a rate of €60bn per month from next month. The European Central Bank will be purchasing national government bonds from member states and, in so doing, it will have become the “lender of last resort” in Europe at last ceding to demands that it provides a backstop to Europe’s fragile sovereign nations in the wake of the financial crisis.

While this has created an uneasy truce between markets and Europe, there is still a long way to go. With QE, systemic risk from sovereign default is avoided and the immediate impact has been to boost equity markets and weaken the value of the euro. Theoretically, this should boost confidence and exports. However, the volatility in markets at present is a product of the broader uncertainty around the effectiveness of QE. Markets need to be convinced that it was the right strategy in the first place, not least because of the broader uncertainties around European geopolitics at present, and are in a mood to test European policy makers in any way they can.

One of the principles of QE is that it reduces the value of the currency and thereby supports real economic growth through exports. Here are the lessons from that trade perspective in four charts:

 

Chart 1  |  US QE – market correction overdue

 

2015-02-23_lessonsFromQE_fig01

 

Figure 1  |  Monthly Value of US exports (USDbn) versus S&P 500, last price monthly
Source  |  DeltaMetrics 2015, Bloomberg

 

The chart shows the close correlation between monthly movements in trade and the S&P 500 at 0.715. Each horizontal line shows the start of a QE programme: December 2008, November 2010 and latterly September 2012. US exports during that time have grown modestly, while the S&P 500 has increased in value substantially faster than its pre-crisis rates, particularly since QE3 in 2012. It appears that one effect of QE has been to worsen the disconnect between asset values and the real economy up to the start of this year.

 

Chart 2  |  Abenomics and the paradox of the yen

 

2015-02-23_lessonsFromQE_fig02

 

Figure 2  |  Monthly value of Japanese exports versus JPY per USD spot price, Last Price Monthly, June 2001-Dec 2015
Source  |  DeltaMetrics 2015, Bloomberg

 

Japan’s relationship with QE has been a long one and has produced a bizarre result: except for the period between October 2004 and May 2007, the relationship between the strength of the yen and exports has been the reverse of what would be expected. As the value of the yen strengthened between June 2001 and October 2004, exports increased. Similarly, as the value of the yen decreased shortly before the implementation of Abenomics in 2012 through to Shinzo Abe’s final asset purchases in October 2014, export trade actually fell. This is a lesson for the developed world economies: exports are currency inelastic and therefore depreciation is unlikely to have much impact on export-led growth.

 

Chart 3  |  UK QE and the export mystery

 

The purpose of UK QE was arguably to protect against systemic risk and loosen up the supply of credit in the banking system to enable bank-to-bank lending. It did not have as its primary focus either exports or real growth. However, as the rest of the world started to pull out of the downturn in the wake of the financial crisis, the question of why sterling had depreciated so much without any impact on exports took on renewed importance. The Conservatives, elected in 2010, set export-led growth as its target and set a goal to double UK exports between 2010 and 2020 to a value of £1 trillion.

 

2015-02-23_lessonsFromQE_fig03

 

Figure 3  |  Monthly value of UK exports (USDbn) vs EURGBP spot (value of 1 euro in sterling), June 2001-Dec 2015
Source  |  DeltaMetrics 2015, Bloomberg

 

UK QE started in September 2009 and was boosted further in October and November 2009. In October 2011 an additional £75bn in QE was announced followed by £50bn each in February and July 2012. Rather than causing the value of sterling to drop, the immediate market reaction was for it to strengthen. Interestingly, the terms of trade are negatively correlated with the value of sterling at -0.754. In other words, exports will grow in value in relation to imports as the value of the currency depreciates. This is exactly as it should be. Yet the facts demonstrate a very weak correlation (0.466) between the value of sterling and exports. QE has strengthened rather than weakened sterling, as in the US, especially against the euro but even so, sterling has not returned to its levels against the euro of 2001 and has therefore depreciated over the whole period, as have exports.

 

Chart 4  |  QE in Europe – a combination of both?

 

Previous trade views have expressed scepticism at the impact on trade of any reduction in the value of the euro. Like Japan, the eurozone’s trade is highly currency inelastic and, as a result, the depreciation of the euro is unlikely substantially to increase exports and therefore provide a much-needed boost to growth.

 

2015-02-23_lessonsFromQE_fig04

 

Figure 4  |  Monthly value of eurozone exports (USDbn) vs Dax Index, Last Price Monthly, June 2001-Dec 2015
Source  |  DeltaMetrics 2015, Bloomberg

 

However, it is likely that the value of European stock markets could increase substantially. The Dax has reached all-time highs since QE was announced and this creates as substantial a disconnect between economic fundamentals and equities in Europe as there has been in the US and the UK. But this QE-induced asset boost, unlike in the US, comes without an accompanying boost to the real economy in the form of infrastructure spending. Instead, it may well come with restrictions on real growth if sovereign responsibility is tied to austerity rather than structural reform and long-term growth.

Policy makers in Europe now have to ask which lessons they want to learn, and from which chart.

Webcast 029 | Europe at a Crossroads

Delta Economics CEO, Dr Rebecca Harding and the Associate Editor of Pieria Frances Coppola, discuss the effect that Quantitative Easing may have on the European economy and some of its likely consequences for businesses. They also analyse issues surrounding Greek debt and weaknesses in the Russian economy.

 

 

Webcast 029 Author  |  Rebecca Harding  |  CEO

Back to reality

Why Dollar-Euro parity is possible  |  Following a turbulent January in Europe, the once unthinkable is now becoming thinkable. Mario Draghi, as was widely trailed, launched €1.1 trillion of Quantitative Easing (QE) to September 2016. And following Syriza’s victory in the Greek election, the prospect of a Grexit is now actively being discussed.

So here’s another “unthinkable”: the euro will reach parity with the US dollar by 2015 and has the potential to fall lower if current volatility and pressures on the currency continue. Is this really unthinkable or is it simply a return to the reality that we saw in the early days of the euro?

First, the Delta Economics view is that the euro has been over-valued for some time, largely as a result of the German trade surplus. Although Europe needs German trade to be strong because of the supply chains that originate in Germany and spread out across Europe, the high value of the euro has made it harder for the internal imbalances of the eurozone to be corrected by export-led growth outside of Germany.

At the outset, markets viewed the eurozone with a degree of scepticism. By June 2001 one euro bought 0.85 US dollars. As time has gone by, eurozone performance has, inevitably perhaps, become more dominated by Germany pushing the value of the euro up and kicking the issues of intrinsic imbalances between Member States down the road. However, instead of resolving imbalances by everyone “becoming more like Germany”, a weaker currency simply reflects the fact that everyone isn’t like Germany.

Second, the fact that QE was necessary in the first place made it abundantly clear that the eurozone is far from a marriage of equals. The euro came under pressure ahead of the announcement and fell to new lows subsequently. But it is here where the facts start to conflict with policy expectations. Theoretically, a lower euro should boost the real economy through trade because exports should become cheaper. However, what we’ve actually seen over the years since the introduction of the euro is a high correlation between the euro’s value and the value of trade: in other words, when the euro goes up, so does trade (Figure 1).

We believe there are two explanations for this: in the first instance, European trade, dominated as it is by Germany France, Italy, the Netherlands and Belgium, is largely at the high end of supply and value chains and therefore does not respond particularly to changes in the value of the currency. Even for weaker nations more dependent on commodities, the importance of Europe-wide supply chains means that the relationship still holds. For example, the correlation of the value of the euro with Greek trade is 0.89.

Furthermore, the value of the euro is actually a signal by the markets about the strength of the European economy: when the economy and institutions seem strong, the value is high and vice versa. In other words, as discussed previously, trade is an important driver of the value of the euro because of its importance as a driver of economic performance in the eurozone generally. While trade is falling, and we are forecasting it will fall by 3.7% within the eurozone in 2015, so too can we expect the value of the euro to fall. The result is that policy can have very little effect on the real economy through currency manipulation.

 

2015-02-03_backToReality_fig01_v01

 

Figure 1  |  Monthly value of eurozone exports, USDbn versus USD per euro spot, Last Price Monthly, June 2001-Dec 2015
Source  |  DeltaMetrics 2015, Bloomberg

 

The third reason why the value of the euro is likely to come under increased pressure is the outcome of the Greek election in January. Syriza is looking to renegotiate its debt and start the process of loosening the tight controls it has had over spending. As with the eurozone more generally, it will not be helped by a lower value of the euro (Figure 2) because of its inter-dependency with trade in the eurozone as a whole through its role as a trade hub.

 

2015-02-03_backToReality_fig02_v01

 

Figure 2  |  Monthly value of Greek total trade (USDm) versus USD per euro spot price, Last Price Monthly, June 2001-Dec 2015
Source  |  DeltaMetrics 2015, Bloomberg

 

Greece’s trade to GDP ratio is 0.4: in other words, there is a fairly strong pull of trade on Greece’s GDP. Oil is a critical part of this: the correlation between Greece’s trade and the oil price is 0.80 – largely because of the importance of oil in Greece’s total trade structure. Greece’s exports of refined oil, for example, are twice as high as the second-largest export sector – medicines.

 

2015-02-04_tradeInsight_fig03_v01

 

Figure 3  |  Greece’s debt and the challenge of trade
Source  |  DeltaMetrics 2015

 

Greece’s trade is just 0.4% of Europe’s total trade; however, their trade is nevertheless important both because of the impact that it has on the prospective growth of the Greek economy and as a portent for the negotiations about debt restructuring, austerity and structural reform ahead. Put simply, if a low-valued euro is unlikely to help boost Greek (or eurozone for that matter) trade more generally, then there is little that monetary policy at a European level can do to help long-term growth in the peripheral nations. Greece’s debt is, according to Syriza, not repayable and imposes too many restrictions on the Greek economy. One option is to set debt repayments against growth targets but, given falling oil prices and falling intra-European trade, this looks ambitious.

The eurozone needs more than QE and a low value of the currency for growth. The eurozone’s peripheral nations’ struggle for growth is accentuated by the fact that they must trade in euros internally and externally. Given “austerity” constraints attached to their sovereign debt, this makes it very difficult to grow. There will continue to be sustained political dissent between Member States on the best way to resolve the issue of Greece, and there is a danger that the debate will spill over to other nations, like Spain, Ireland and Portugal.

All of which brings us back to reality with a harsh bump. The likely outcome of all of this is continued market pressure on the euro (Figure 4).

 

2015-02-03_backToReality_fig04_v01

 

Figure 4  |  Monthly value of eurozone exports versus USD per Euro spot price and linear forecast, Jan 2014-May 2016
Source  |  DeltaMetrics 2015, Bloomberg, Delta Economics analysis

 

The pressure on the euro over the last year has mostly been downwards. The Delta Economics asset price forecasting model, which is itself based on country-sector-partner trade flows, is indicating short positions on the euro for most of 2015. Even if the trend continues in a linear way as it has done over the past 12 months, this suggests parity by the end of the year. Whether this will bring the eurozone “back to life” is uncertain, but we are certainly “back to reality”.

 

Back to reality: why Dollar-Euro parity is possible  |  Trade View Author  |  Rebecca Harding  |  CEO

Webcast 028 | Back to reality

Why Dollar-Euro parity is possible  |  January was a turbulent month in markets and politics. There was really only one story in town: European quantitative easing and the Greek election. What does this mean for trade and markets?

 

 

Webcast 028 Author  |  Rebecca Harding  |  CEO

The Fallacy of Quantitative Easing

There is no doubt the EU project has benefited the German economy above all else: a bit like the cat got all the cream and then some. But it cannot be put off any longer; as Voltaire once said, with great power comes great responsibility. In an unusual act of defiance against German apprehension to the ECB’s sovereign bond-buying programme, the ECB will press ahead with QE1. There will be a week to thrash out the exact details after the ECJ verdict on 14th January on the legality of such a move, but a formal announcement is expected on 22nd January.

The decision to “press the button” is more likely now than ever before given the falling prices in the Eurozone. Some would argue that we are being too quick to diagnose a deflationary spiral: that these are just temporary falls in prices. The truth is that falling prices were evident in the Eurozone long before the recent external (oil) supply shock took effect. Europe’s problems run much deeper.

In the short term, any announcement in QE is unlikely to be large enough or make a significant impact on economic fundamentals: much like plugging holes in a leaking dam. QE will only act as a plaster over the real structural differences that besiege the Eurozone. Indeed, some of the world’s major economies have implemented QE with dubious results: the USA has been through three rounds of QE with more favourable outcomes, however, whether that’s purely down to QE or other more dynamic variables has yet to be proven. The UK has gone through two rounds: with the first being more effective than the second. Japan on the other hand has had to endure NINE rounds of injections (yes, QE9!) with little effect. Even after 20+ years, the legacy of deflation is engrained and growth remains elusive.

In the more medium term, what is clear is that QE will contribute to bloating banks’ balance sheets, with little in the way of affecting the real economy. This is unlikely to prompt banks to lend more. On the contrary, the winners of QE will be the bond holders, mostly the well-off, whom are unlikely to spread to the gains evenly around the economy, but would rather pile into assets thus further perpetuating asset price inflation. It’s an inefficient allocation of resources: the “wrong” people are being targeted.

What else if not QE one might ask? Recent reports suggest that Japan is toying with the idea of implementing a more innovative monetary policy tool known as “helicopter money”: dropping money directly into the pockets of every citizen. Whilst this would target the “right” people, it may all be too radical for the bureaucrats of Europe. Many economists view this measure with great suspicion partly because it hasn’t been tested robustly enough. However, the belief that prices will fall further may already be entrenched into the minds of EU citizen, so any windfall in the way of helicopter money (if too small) may be squirrelled away rather than spent on stimulating the local economy. Introducing a voucher- based system for certain goods and services is marginally better, but this too comes with a host of complications in terms of which good and services qualify, and ensuring money is not leaked out of the system.
It will need more than QE to resuscitate the Eurozone. A Eurozone break up is out of the question no matter how necessary it may be in economic terms: politics will trump economics. What is more likely is that there will be QE-light – but this still falls short of what is really needed: further structural reforms and deeper fiscal consolidation. One thing is for sure: being timid never got anyone anywhere…

 

The Fallacy of Quantitative Easing  |  Author  |  Shefali Enaker  |  Economist

Demanding times

Why Europe urgently needs to focus on long term competitiveness  |  The Eurozone has a problem, but not the one that policy makers thinks it has. On the face of it, prices falling by 0.1% between October and November, growth at 0.2% in Q3 and unemployment at 11.5% is quite enough to concentrate minds as ECB policy makers sit down at their next meeting on the 4th December. The ECB is coming under increased pressure to stimulate demand across the Eurozone in order to stave off disinflationary pressures that may result in deflation and hence raise the spectre of the Eurozone becoming like Japan: negative price increases alongside near-to-zero growth.

But the problem is not disinflation, nor even deflation as such. It is long term competitiveness and the policy paradoxes that have taken the Eurozone, and, indeed the whole world to the brink of a low inflation, low growth normality as oil prices continue to tumble.

Within Europe the problem is not the willingness to boost investment through Quantitative Easing (QE) and low interest rates. The ECB is already committed to sovereign Bond purchases for peripheral nations if those nations commit to structural reform, which, while contested by Germany and its Constitutional Court, represents a statement of intent. Alongside the promise for corporate bond and asset backed security purchases, the ECB is clearly in the market for some form of QE alongside negative interest rates if necessary.

The policy paradox is this: the solutions that are currently under discussion are aimed at the monetary side of the Eurozone economy while having the effect of contracting the real, demand, side of the economy. By definition, monetary instruments are being used to shore up the banking sector, to inject financial stability into the system and to reflate the economy by increasing the money supply. The hope is that by creating a financially stable system, credit conditions will loosen and, alongside structural reforms and austerity at a national level, will naturally generate growth over the long –term. But the austerity packages and national structural reforms alongside this flatten demand and therefore the capacity for the policies to work over the long term.

One measure of just how flat demand and of how important the drive for greater competitiveness should be is trade. The picture for Europe does not look good: the value of European exports is forecast to decline outside of the EU by 0.5% in 2015 which is a long way from the robust export-led growth that the region needs. Within European EU28 trade is forecast to decline by 3.5% and Eurozone trade by 3.7% over the next year, as shown in Figure 1 which illustrates imports trade within Europe and into Europe from non-EU countries.

 

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Figure 1  |  Monthly value of intra and extra EU and Eurozone imports (USDbn)
Source  |  DeltaMetrics 2014

 

Imports from outside of the EU are forecast to drop by 1.45%. Much of the drop in imports from non-EU countries has to do with the falling oil prices (Figure 2). 7 out of the top 10 oil importers into Europe are not in the EU28 and as 30% of the EU’s imports in value terms are oil and gas, the link between falling import values and the reduction in oil prices is clear. There is a 94% correlation between EU imports from non-EU countries and the oil price: the flat trade forecast for 2015 therefore, suggests that there may be some small upward correction in oil prices but nothing substantial until the end of Q1.

 

2014-12-03_demandingTimes_fig02

Figure 2  |  Monthly value of EU imports from non-EU countries, June 2001-Dec 2015 (USDbn) vs NYSE Arca Oil Spot, Last Price Monthly, June 2001-Nov 2014
Source  |  DeltaMetrics 2014, Bloomberg

 

In theory, this helps the EU and the Eurozone because it reduces producer costs and, hence, arguably prices as well. Disinflation, which is simply falling prices, is catalysed by lower oil prices but does not in itself represent anything negative.

Of more concern is the forecast drop in intra regional trade between EU28 and Eurozone countries, which is forecast to fall by 3.5% and 3.7% respectively. Much of this trade is dominated by high-end manufactured goods, for example, automotives, consumer electronics, pharmaceuticals and machinery. If demand for these products is falling (Figure 3) then it suggests a deeper malaise within the system that is triggered by disinflation but leads ultimately to lower demand.

 

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Figure 3  |  Europe’s demand problem
Source  |  DeltaMetrics 2014

 

Europe clearly has a problem: it’s demand for the higher end products that have defined its consumption patterns in the past is falling: demand for cars will fall by around 5% in 2015 and demand for medicines by 2.4% and 0.6% respectively. This matters for the world because, if demand is falling, then Europe has the potential to transmit its lower demand through the trade system to the rest of the world since it accounts for 44% of medicines, 34% of cars and 26% of computer imports across the world.

So if Europe is demanding less, then, accordingly, other countries will see their aggregate demand affected by the drop in trade to Europe as net exports drag further on global GDP. This is reflected in the forecast for European car and medicines exports, both top ten trade sectors for the world, which are set to fall by around 1% in 2015. As EU produced Pharmaceuticals account for 64% of all world exports, and cars for 50%, this suggests a tough year ahead.

All is not lost and the highest end, research-led exports from Europe, aircraft and biopharmaceuticals are set to grow significantly. In other words, the challenge for European policy makers is to ensure that Europe remains competitive at the highest end of the manufacturing supply chain where it already dominates global exports.

It is unlikely that the ECB will consider QE on Thursday and most economists expect any European QE to happen in Q1 2015 at the earliest. Delta Economics is of the view that European long term competitiveness is now a more pressing issue than addressing issues of disinflation. A substantial boost to European and domestic infrastructures, particularly to support high end manufacturing industry, is a necessary counterpart to any austerity measures to bring wayward budgets under control. Any QE at any point will be potentially necessary to stabilise international markets but not sufficient to fuel long term growth.