By David J. Powell, author of The Trader’s Guide to the Euro Area
A deceleration of inflation is likely to eventually force the European Central Bank to ease monetary conditions again and maintain loose policy for the foreseeable future.
Inflation in the euro area is trending downward. The headline HICP reading fell to 0.7 percent year over year in October from 1.1 percent in September. It has declined from a recent peak of 3 percent in November 2011.
The latest inflation data revealed the Governing Council is significantly undershooting its target. The ECB “aims to maintain inflation rates below, but close to, 2 percent over the medium term.”
Inflation has also been weaker than forecast by the staff economists. They projected in September an HICP inflation reading of 1.5 percent for 2013 and 1.3 percent for 2014.
Updated forecasts will be published in December. Estimates for GDP and inflation produced jointly by “experts from the ECB and from the euro area national central banks” are released biannually in June and in December. The ECB staff “complements” those projections with updates in March and in September.
The core reading paints an equally grim picture. It declined to 0.8 percent year over year in October from 1 percent in September. It peaked most recently in July 2012 at 1.7 percent. The core figure measures inflation inertia.
Lending data give reason for concern as well. Loans to non-financial corporations, adjusted for sales and securitization, fell 2.7 percent year over year in September versus minus 2.9 percent in August. The equivalent figure for households stood at 0.3 percent year over year, unchanged from the previous month.
That has caused the ECB to veer from the aims of the second pillar of its monetary-policy strategy as well. The three-month average of M3 money supply growth fell to 2.2 percent year over year in September from 2.3 percent in August. Those figures compare with the central bank’s “reference rate” of 4.5 percent.
Slack in the economy is likely to continue weighing on inflation. The unemployment rate remained at a record high of 12.2 percent in September. The OECD estimates the non-accelerating inflation rate of unemployment for the region to be 9.8 percent.
The recovery appears too weak to counter that problem. The level of GDP is still about 3 percent below its pre-crisis peak.
The euro-area economy emerged from recession during the second quarter of this year. It grew 0.3 percent quarter over quarter. The increase in total output followed six consecutive quarters of contraction. The year-over-year figure stood at minus 0.6 percent
A Taylor Rule model suggests easing is required to nurture the recovery. The monetary policy tool, based on coefficients estimated by the Federal Reserve Bank of San Francisco, suggests the one-week refinancing rate should be reduced to minus 0.25 percent. That compares with the present level of 0.25 percent. The signal is the result of low core inflation and high unemployment.
The hawks on the Governing Council have latched on to signs of recovery to oppose additional easing. The two best coincident indicators of GDP growth – the PMI surveys and industrial production – have provided them with some support.
The composite PMI survey suggests the expansion continued during the third quarter. The headline reading stood above 50 during July, August and September. It also remained above that threshold during the first month of the fourth quarter. The PMI surveys are the timeliest indicators of the present state of the economy and among the first monthly economic indicators released.
Industrial production data paints a similar picture. The index rose 1 percent month over month in September, though the year-over-rate registered minus 2.1 percent.
Industrial production provides a good indicator of overall GDP. A regression of industrial production growth on a quarter-over-quarter basis on GDP in the same form suggests that it explains 64 percent of the variation in overall output using data from the first quarter of 1995 to the second quarter of 2013.
The German Ifo survey – a leading indicator – also provides reason for optimism. The expectations component rose to 103.6 in October from a recent trough of 93.3 in September 2012.
The Ifo survey has been a good indicator of the euro-area economy as a whole, though the survey is only based on feedback from companies in Germany, the continent’s largest economy. The quarterly average of the expectations component of the survey tends to lead the year-over-year rate-of-change of euro-area GDP by three to six months. When the publishing lag is included, the lead is about four to seven months.
The German ZEW survey is sending a similar signal. The expectations component rose to 52.8 in October – the highest level since April 2010 – from a recent trough of minus 55.2 in November 2011.
The survey has also been a good indicator of the euro-area economy as a whole, though it is only based on feedback, with a few exceptions, from financial analysts in Germany. The quarterly average of the expectations component of the ZEW survey is most highly correlated with year-over-year euro-area GDP growth with a lead of three quarters.
Real M1 money supply growth is also signaling a recovery. The latest year-over-year figure – for the month of September – stood at 5.5 percent. That compares with a recent trough of minus 1.4 percent in June 2011. Real M1 money supply growth is the indicator of economic growth that provides the longest lead. It leads GDP growth by about four quarters.
The system of “consensus” building used by the Governing Council has allowed dissenters to squash the will of the majority. For example, most of the body’s members wanted to reduce the main policy rate of the ECB in December 2012 and the move was reportedly blocked by President Mario Draghi and Executive Board members Benoit Coeure and Joerg Asmussen as well as Bundesbank President Jens Weidmann.
The system still appears to allow the president to impose his will on the Governing Council by only selectively proposing a vote on matters of monetary policy. For example, in August 2012, Draghi appeared to suggest that he would overcome the opposition of Weidmann to the purchase of government bonds by having the latter outvoted.
Draghi appears to have repeated that act at the meeting in November. He will probably find himself in a similar position in the months – and possibly even years – to come.
About the Author:
David J. Powell is the author of The Trader’s Guide to the Euro Area: Economic Indicators, the ECB and the Euro Crisis. He is an economist at Bloomberg LP in London where he focuses on euro-area economics and currencies. Previously, he worked at Bank of America – Merrill Lynch as a currency strategist. He holds a master’s degree from the London School of Economics and Political Science, where he wrote his dissertation on the creation of monetary union in Europe, and a bachelor’s degree from New York University.
The Trader’s Guide to the Euro Area: Economic Indicators, the ECB and the Euro Crisis is published by Bloomberg, an imprint of Wiley, priced £29.99.
Economic recovery likely to prove a ‘stuttering’ affair
By Rupert Thompson, Chief Investment Officer at Kingswood
Equity markets continued their upward trend last week, with global equities gaining 1.2% in local currency terms. Beneath the surface, however, the recovery has been a choppy affair of late. China and the technology sector, the big outperformers year-to-date, retreated last week whereas the UK and Europe, the laggards so far this year, led the gains.
As for US equities, they have re-tested, but so far failed to break above, their post-Covid high in early June and their end-2019 level. The recent choppiness of markets is not that surprising given they are being buffeted by a whole series of conflicting forces.
Developments regarding Covid-19 as ever remain absolutely critical and it is a mixture of bad and good news at the moment. There have been reports of encouraging early trial results for a new treatment and potential vaccine but infection rates continue to climb in the US. Reopening has now been halted or reversed in states accounting for 80% of the population.
We are a long way away from a complete lockdown being re-imposed and these moves are not expected to throw the economy back into reverse. But they do emphasise that the economic recovery, not only in the US but also elsewhere, is likely to prove a ‘stuttering’ affair.
Indeed, the May GDP numbers in the UK undid some of the optimism which had been building recently. Rather than bouncing 5% m/m in May as had been expected, GDP rose a more meagre 1.8% and remains a massive 24.5% below its pre-Covid level in February.
Even in China, where the recovery is now well underway, there is room for some caution. GDP rose a larger than expected 11.5% q/q in the second quarter and regained all of its decline the previous quarter. However, the bounce back is being led by manufacturing and public sector investment, and the recovery in retail sales is proving much more hesitant.
China is not just a focus of attention at the moment because its economy is leading the global upturn but because of the increasing tensions with Hong Kong, the US and UK. UK telecoms companies have now been banned from using Huawei’s 5G equipment in the future and the US is talking of imposing restrictions on Tik Tok, the Chinese social media platform. While this escalation is not as yet a major problem, it is a potential source of market volatility and another, albeit as yet relatively small, unwelcome drag on the global economy.
Government support will be critical over coming months and longer if the global recovery is to be sustained. This week will be crucial in this respect for Europe and the US. The EU, at the time of writing, is still engaged in a marathon four-day summit, trying to reach an agreement on an economic recovery fund. As is almost always the case, a messy compromise will probably end up being hammered out.
An agreement will be positive but the difficulty in reaching it does highlight the underlying tensions in the EU which have far from gone away with the departure of the UK. Meanwhile in the US, the Democrats and Republicans will this week be engaged in their own battle over extending the government support schemes which would otherwise come to an end this month.
Most of these tensions and uncertainties are not going away any time soon. Markets face a choppy period over the summer and autumn with equities remaining at risk of a correction.
European trading firms begin coming to terms with the new normal
By Terry Ewin, Vice President EMEA, IPC
In recent weeks, the phrase ‘never let a good crisis go to waste’ has received a large amount of usage. Management consultancies, industry associations and organisations, including the Organisation for Economic Co-operation and Development (OECD) have all used it in order to discuss how the current crisis, caused by the Coronavirus pandemic, presents an opportunity for new and worthwhile change.
The saying is also commonly used to indicate that the destruction and damage that is caused by a crisis gives organisations the chance to rebuild, and to do things that would not have previously been possible. This has the potential to impact financial trading firms, where projects that this time last year would not have made much sense now appearing to be as clear as day. In Europe, banks and brokers alike are beginning to think about what life will look like post-pandemic, and how their technology strategies may need changing.
We can think of three distinct phases when it comes to a crisis. Firstly, there is the emergency phase. This is followed by the transition period before we come to the post-crisis period.
Starting with the emergency phases, this is when firms are in critical crisis management mode. Plans are activated to ensure business continuity, and banks and brokers work to ensure critical functions can still take place so as to continue servicing their clients. With regards to the current crisis period, both large and small European banks and brokers were able to handle this phase relatively well, partly due to the fact that communications technology has reached the point where productive Work From Home (WFH) strategies are in place. For example, cloud-connectivity, in addition to the use of soft turrets for trading, has enabled traders from across the continent to keep working throughout lockdown. From our work with clients, we know that they were able to make a relatively smooth transition to WFH operations.
In relation to the current coronavirus crisis, we are in the second phase – the transition period. This is the stage when financial companies begin figuring out how best to manage the worst effects of the ongoing crisis, whilst planning longer-term changes for a post-crisis world. One thing to note with this phase, is that no one knows how long it will last. There is still so much we don’t know about this virus. As such, this has an impact on when it will be safe for businesses to operate in a similar way to how they were run in a pre-pandemic world. But with restrictions across Europe starting to be eased, there is an expectation that companies will start to slowly work their way towards more on-site trading. For example, banks are starting to look at hybrid operations, whereby traders come in a couple of times a week, and WFH for the rest of the week. This will result in fewer people in the office building, which makes it easier to practise social distancing. It also means that there is a continued reliance on the technology that enables people to WFH effectively.
Finally, we have the post-crisis period. In terms of the current crisis, this stage is very unlikely to occur until a vaccine has been developed and distributed to the masses. Although COVID-19 has caused mass economic disruption, many analysts are predicting a strong rebound once the medical pieces of the puzzles are put into place. It may not be entirely V-shaped, but the resiliency displayed by the financial markets thus far suggests that it will be healthy.
Currently, many European trading firms are taking what could be described as a two-pronged approach.
The first part of this consists of planning for the possibility of an extension to phase two. Medical experts have suggested that there could be some seasonality to the virus, with the threat of a second wave of COVID-19 cases in the Autumn meaning that the risk of new restrictions remains. If this comes to fruition, there would be a need for organisations to fine-tune their current WFH strategies and measures, and for them to take greater advantage of the cloud so as to power communications apps.
The second component consists of firms starting to think about the long-term needs of their trading systems. Simply put, they are preparing themselves for the third phase.
It is in this last sense, that the idea of never letting ‘a good crisis go to waste’ resonates most clearly.
Currency movements and more: How Covid-19 has affected the financial markets
The COVID-19 pandemic has been more than a health crisis. With people forced to stay indoors and all but the most essential services stopped for multiple weeks, economies have suffered and financial markets have crashed. Perhaps the most public and spectacular fall from grace during the early stages of the pandemic was oil. With travel bans in place around the world and no one filling up at the pumps, the price of oil plummeted.
Prior to global lockdowns, US oil prices were trading at $18 per barrel. By mid-April, the value had dropped to -$38. The crash was not only a shocking demonstrating of COVID-19’s impact but the first time crude oil’s price had fallen below zero. A rebound was inevitable, and many traders were quick to take long positions, which meant futures prices remained high. However, with stocks piling up and demand sinking, trading prices suffered. Unsurprisingly, it’s not the only market that’s taken a knock since COVID-19 struck.
Financial Markets Fluctuate During Pandemic
Shares in major companies have dipped. The Institute for Fiscal Studies compiled a round-up of price movements for industries listed by the London Stock Exchange. Tourism and Leisure have seen share prices drop by more than 20%. Major airlines, including BA, EasyJet and Ryanair have all been forced to make redundancies in the wake of falling share prices. The automotive industry has also taken a knock, as have retailers, mining and the media. However, in among the dark, there have been some patches of light.
The forex market has been a mixed bag. As it always is, the US dollar has remained a strong investment option. With emerging markets feeling the strain, traders have poured their money into traditionally strong currency pairs like EUR/USD. Looking at the data, IG’s EUR/USD price charts show a sharp drop in mid-March from 1.14 to 1.07. However, after the initial shock of COVID-19 lockdowns, the currency pair has steadily increased in value back up to 1.12 (June 25, 2020). The dominance of the dollar has been seen as a cause for concern among some financial experts. In essence, the crisis has highlighted the world’s reliance on it.
Currency Movements Divide Economies
In any walk of life, a single point of authority is dangerous. Indeed, if reliance turns into overreliance, it can cause a supply issue (not enough dollars to go around. More significantly, it could cause a power shift that gives the US too much control over economic policies in other countries. Fortunately, other currencies have performed well during the pandemic. Alongside USD and EUR, the GBP has also shown a degree of strength throughout the crisis. However, these positive movements haven’t been shared by all currencies.
The South African rand took a 32% hit during the early stages of the pandemic, while the Mexican peso and Brazilian real dropped 24% and 23%, respectively. Like the forex market, other sectors have experienced contrasting fortunes. Yes, shares in airlines and automotive manufacturers have fallen, but food and drug retailers have seen stocks rise. In fact, at one point, orange juice was the top performer across multiple indices. With the health benefits of vitamin C a hot topic, futures prices for orange juice jump up by 30%. The sudden surge had analysts predicting 60% gains as we move into a post-COVID-19 world.
Looking Towards the Future through Financial Markets
The future is always unknown and, due to COVID-19, it’s more uncertain than ever. However, the financial markets do provide an indication of how things may change. The performance of USD and EUR in the forex markets suggest there could be a lot more trade deals negotiated between the US and Europe. The surge in orange juice futures suggest that health and wellness will become a much more important part of our lives. Even though it was already a multi-billion-dollar industry, the realisation that a virus can alter the face of humanity has given more people pause for thought.
Then, of course, there’s the move towards remote working and socially distance entertainment. From Zoom to Slack, more people will be working and playing from home in the coming years. The world is always changing, but recent have events have made us appreciate this fact more than ever. The financial markets aren’t a crystal ball, but they can offer a glimpse into what we can expect in a post-COVID-19 world.
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