Cumberland Advisors Market Commentary – Eurozone Economy Risks A Decline With Divided Central Bank

Author: William Witherell, Ph.D., Post Date: October 4, 2019
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The latest September data for the eurozone economy from IHS Markit present a deteriorating picture, with the demand for goods and services falling at its fastest rate in over six years and a deepening recession in manufacturing.

Cumberland Advisors Market Commentary by William "Bill" Witherell, Ph.D.

Sentiment about the future, affected by concerns about global growth prospects, trade wars, and geopolitical uncertainties, remains at six-year lows. It is not surprising that outgoing European Central Bank (ECB) President Mario Draghi warned that the Eurozone faced “more protracted weakness” than the ECB previously thought. He called for urgent fiscal policy action by European governments to compliment the ECB’s set of monetary easing measures announced on September 12.

Despite some strong opposition discussed below, Draghi was able to obtain agreement at the September meeting for using almost all the tools available to the bank. The ECB’s quantitative easing program of bond purchases, on hold since the end of 2018, is to be relaunched starting in November with no set end date. The ECB’s policy rate, the rate for bank deposits placed with the central bank, was reduced another 10 basis points from -0.40% to -0.50%. In order to limit the negative effect for banks, a tiering system for banks was announced that will exempt some of banks’ excess reserves (about six times their minimum reserves) from the sub-zero rates. This system will be beneficial for the Northern European banks, which have large excess reserves. Also, the ECB will be sweetening the terms and extending the loan maturity in a third targeted longer-term refinancing operation, TLTRO, which has the objective of stimulating more lending by banks. This action is expected to benefit Southern European banks, which face higher lending costs.

In announcing this stimulus, Draghi told reporters that “a clear majority” of the ECB’s Governing Council were in favor of the package. However, reports indicate that 9 of the 25 members of the Council expressed their opposition and that there are deep divisions at the senior level within the bank. One council member, Klaas Knot, head of the Dutch national bank, expressed his open dissent, a rare move, calling the package “disproportionate to the present economic conditions.” Jens Weidmann, president of the Bundesbank, said that Draghi was “overshooting the mark.” The heads of the French and Austrian central banks also publically opposed the ECB’s latest actions. The backlash against the ECB stimulus was underlined by the surprise resignation of Germany’s Sabine Lautenschlaeger, another monetary policy hawk, from the ECB’s executive board last week two years before her mandate expires.

The dissents concern both some members’ doubts that neither more negative interest rates nor restarting quantitative easing will lead to greater bank lending and the harmful effects of negative interest rates on savers and banks. Some feel that these measures will distort asset prices. And the northern eurozone members of the council appear to agree with Weidmann that “the economic situation is not all that bad.” The Financial Times argues that this view is “complacent.” This writer agrees. In its latest outlook the OECD has lowered its growth forecasts for the eurozone to 1.1% in the current year and 1.0% for 2020. Germany’s growth forecasts are just 0.5% and 0.6%, respectively.

Investors also appear to have some doubts about how effective the stimulus package will be. The public dissension within the ECB Governing Council certainly doesn’t help. The deep division within the ECB is raising questions for investors as to whether the ECB will be able to agree on further monetary easing if needed, to do “whatever it takes”. Christine Lagarde, who will replace Draghi on November 1, will need to give priority to rebuilding consensus.

The ECB believes that the tiering of excess reserves will be effective in shielding the interest margins of banks from the effects of even more negative interest rates and that should limit banks’ seeking to pass the negative rates onto retail depositors. The experience of such tiering in Switzerland, Japan, and Denmark has been mixed and their tiering exemptions are considerably larger. Draghi insists that negative interest rates are a necessity in the current situation in view of the ECB’s price stability mandate. He also has emphasized that with respect to concerns about limits on the ECB’s ability to buy more bonds, the buying could continue for quite a long time under the current limitations.

Eurozone stocks continue to maintain a relatively strong performance despite the headwinds of deteriorating economic data and trade and geopolitical uncertainties.  The iShares MSCI Eurozone ETF, EZU, is still up 10.9% year-to-date as of September 30, which is better than the 9.8% gain of the iShares MSCI All Country Ex US ETF, ACWX. Within the eurozone, national market performance varied considerably. Reflecting an economy on the cusp of recession, the iShares Germany ETF, EWG, is up just 6.2% year-to-date. In contrast, the iShares MSCI France ETF, EWQ, has gained 13.7%, as the French economy has shrugged off the effects of political demonstrations and investors have been encouraged by the economic reform efforts of President Macron. If governments heed the call for increased fiscal stimulus by countries in a position to make stimulus happen, the prospect for eurozone equities should strengthen.

Bill Witherell, Ph.D.
Chief Global Economist & Portfolio Manager
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Sources: Financial Times, OECD.org, market.com, cnbc.com.


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