The European Central Bank’s enormous stimulus has strengthened eurozone financial markets’ resiliency, but it has also made them dependent on ongoing
stimulus to maintain stability. Weaning markets off easy monetary policy will be a delicate exercise for the ECB and is a topic we think will gain
prominence next year – and one that reinforces our long-term caution about investing in the eurozone.
The ECB effectively saved the euro in 2012 by acting as “lender of last resort” to its financially troubled sovereign shareholders. Fiscal policymakers
assisted too, ultimately establishing the European Stability Mechanism (ESM) to support eurozone countries in financial difficulty and laying the
foundations of a banking union.
The ESM added an important fiscal pillar (alongside the ECB’s monetary one) to the eurozone governance structure, which lacks its own parliament and
budget. With little more than €80 billion of paid-in capital, the ESM’s fiscal resources are limited. Yet with the ECB buying vast quantities of its
shareholders’ government bonds, ESM resources are needed only in Greece, which has yet to regain market access.
Further near-term easing
Now that the eurozone crisis has receded, the ECB has refocused on price stability. Since the bank defined price stability in 1998 as the rate of consumer
inflation “below, but close to, 2%,” inflation has averaged 1.7% annually, and it has lagged the 2% upper bound since 2014. The ECB projects it to rise
from 0.4% currently to 1.2% in 2017 and 1.6% by 2018 (see Figure 1). Five years of low price increases would risk entrenching inflation expectations below
target – a key reason we think the ECB will ease again.
So far, the ECB has cut its main refinancing rate to zero and its deposit facility rate to -0.4%, and has committed to purchase €1.7 trillion of bonds
through March 2017. This will expand its balance sheet to 17% of gross domestic product (GDP). We expect the Governing Council to announce further easing
measures at its 8 December meeting, when it will also publish updated economic forecasts that we believe will show inflation on target by 2019. We think
the package of measures will include an extension of quantitative easing (QE) by six to nine months at the existing purchase rate of €80 billion per month,
bringing asset purchases to 20%-23% of GDP.
We believe any extension of QE will require the ECB to relax some of its current rules for purchasing government bonds, which mandate:
Bond yields at or above the deposit facility rate (-0.4%)
Geographical distribution of purchases in line with the ECB’s capital key
Purchases not to exceed 33% for any one bond or issuer
Because the capital key rule requires the ECB to buy more German government bonds than those of any other member state, and because nearly two-thirds of
all Bunds yield less than -0.4%, an extension of QE will make it challenging for the ECB to find sufficient Bunds to buy. In our baseline, where the ECB
extends QE by six to nine months, we estimate it would need to buy between €80 billion-€130 billion in Bunds under current rules. Yet applying the three
rules above, there are currently only about €130 billion of Bunds outstanding that the ECB could conceptually buy, and the majority of them have long
maturities between 20 to 30 years. Life insurance companies plausibly hold the lion’s share of these bonds and are unwilling sellers; these securities help
match their liabilities to policyholders and meet book accounting rules, and alternative assets are in short supply.
Were the ECB to concentrate remaining purchases on these long-maturity Bunds, we believe it would unduly flatten the yield curve. This could undermine
financial stability for banks and insurance companies, which tend to borrow short and lend long and thus prosper when yield curves are steep. With this in
mind, we think it’s plausible that the ECB would relax all three rules if it extends QE.
Two exit scenarios
Although the minutiae of the ECB’s next steps are important, long-term investors must consider other factors too. At PIMCO, we’re interested in how assets
that are currently supported by monetary policy will fare once central banks remove stimulus. In other words, what is the fair value of an asset without
its monetary support?
When former Federal Reserve Chairman Ben Bernanke said the Fed would “taper” asset purchases in 2013, global bond yields and risk premia rose sharply. And
reports earlier this month that the ECB might consider tapering purchases (which the bank denied) briefly caused yields to rise. The market’s logic seems
to be that if adding QE lowers long-term real interest rates, subtracting it will raise them.
But the context matters. U.S. Treasury bond yields are broadly similar now to levels just before the Fed announced its intention to taper in 2013, and
growth and inflation also play a role. Consider, then, two economic scenarios under which the ECB might taper.
Spare capacity. In this scenario, while some spare labor and investment capacity remains in parts of the eurozone, the unintended costs of loose monetary policy begin to
outweigh the benefits, prompting the ECB to wind down QE. The risk for investors is that stopping QE while growth remains sluggish could cause bond yields
to rise to levels that rekindle concerns about debt sustainability – especially for countries with high debt burdens and low rates of economic growth.
Consider Italy, for example, where gross public debt equals 133% of GDP. To stabilize debt at this level, Italy must meet several conditions: a primary
budget surplus, low interest rates and economic growth. With help from the ECB’s accommodative monetary policy, Italy satisfies all three. Its primary
budget surplus will be 2.2% of GDP this year, according to the European Commission; Bloomberg data show a weighted average yield on public debt of just
0.5%; and its nominal GDP grew at a 2% annual rate during the first half of this year, according to Eurostat.
But how sensitive is Italy’s debt sustainability to different interest rate and growth scenarios? At a 2% nominal GDP growth rate and a 4% nominal interest
rate, the Italian government would need to run a 2.6% primary surplus to stabilize debt, not far from where it is today (see Figure 2). So Italian
government bond yields would need to rise a lot – by 3.5 percentage points – before Italy’s primary budget surplus would need to expand. But if nominal
growth slowed to 1% and government bond yields rose to 4%, the primary budget surplus would have to rise to 4% to keep debt stable relative to GDP.
Investors should therefore bear in mind two things. First, economic growth in Italy is low, and reforms are needed to boost its potential. Nominal GDP
growth has averaged just 0.2% annually since 2009, and current growth owes largely to easy monetary conditions. Second, Italy is too big for the ESM to
rescue. The government’s ability to reform, which the upcoming constitutional referendum will test, is an important determinant of how Italian assets might
perform when the ECB exits.
No spare capacity. In this scenario, actual growth rises to potential, closing the output gap – exactly what the ECB aims for and enabling it to exit. What concerns us here
is the sustainability of the southern European countries’ current account balances. This region started on the euro with a small current account deficit
and just over 11% unemployment (see Figure 3). During the boom leading up to the financial crisis, unemployment fell to 7% and the current account deficit
widened to 7% of GDP. Foreign capital, which financed the current account deficit, fled during the crisis, causing growth to collapse and the current
account to eventually swing nine percentage points of GDP back to a 2% surplus – but at the cost of 16% unemployment.
If these countries were somehow to regain full employment, it’s plausible that their current accounts would revert to deficit, for there is little in the
terms of trade or export composition to suggest a structural improvement in their external balances. While the recent decline in unemployment and increase
in the current account surplus is welcome, we attribute it mostly to the lagged effect of the euro’s depreciation – that is, to ECB monetary policy.
If the current account does return to deficit, investors need to consider the appropriate risk premia for countries that depend on foreign private capital.
Alternatively, if the euro appreciates as a result of the ECB exiting QE, high unemployment may persist, fueling social discontent.
Implications for asset allocation
Both scenarios are extreme. And while we think the first better describes the economic landscape ahead, the ECB is unlikely to remove its stimulus until
inflation is solidly on track to 2%. We view tapering, therefore, as a topic for 2017 and beyond.
In thinking about asset allocation decisions, however, we must weigh both the unintended consequences of ultra-loose policy and the political dimension of
high unemployment, especially if both conditions persist.
The policy objective of lowering short- and long-term real interest rates is to revive credit growth. Borrowers benefit from lower interest rates and
savers from one-off gains in asset prices. But there is scant evidence that increased wealth induces consumption and investment. For savers and those
dependent on interest income, lower interest rates may even induce a Ricardian response
by necessitating them to save more or cut costs.
Calls for referenda on euro membership by some political parties – including Italy’s Five-Star Movement, France’s National Front and the Alternative for
Germany – make for an awkward backdrop against which to conduct monetary policy and to invest.
For the ECB, navigating an exit from QE and negative rates poses a thorny challenge. Having rescued the euro, it hardly wants to become a source of renewed
volatility. In the worst case, the ECB could wind up in monetary policy limbo: unable to exit because it wishes to keep government bond yields sustainable,
but unable to go on for risk of overstepping its mandate. And questions would then resurface about the ESM’s capacity to handle crisis management and
whether the political will exists for stronger, more democratic fiscal tools for the eurozone.