Thoughts through the cycle: W2 May ’20

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  • The 2019 HBO production ‘Chernobyl’ provides a masterclass in the mini-series genre. This is not a matter of content – read elsewhere for lazy and superficial comparisons between the world’s worst nuclear disaster and the current Covid-19 pandemic. What is interesting is the form the drama’s five episodes takes: a sudden and unexpected catastrophe; the immediate panic in the aftermath; the subsequent realisation of a greater impending disaster from a meltdown; the lengthy and costly recovery process; finally, the court case to establish the causes and to punish those responsible. Like a Shakespearean tragedy, it comes in five acts. Were we to make a comparison to 2020, we are likely somewhere between Act 2 (immediate panic) and Act 3 (comprehending a potential meltdown).
  • A meltdown at Chernobyl was avoided. Using the format of a show-trial, the denouement of the mini-series brilliantly ties together the intertwining strands of causality that led to disaster. Institutional failings, poor practice, policy decisions, ambitions and other human failings all feature in the path to the explosion on the 26th April 1986. With this in mind, the European Commission’s spring forecast (06/05/2020) has just warned of, “severe distortions within the single market and to entrenched economic, financial and social divergences between euro area member states that could ultimately threaten the stability of the economic and monetary union.” For Europe, this is not core meltdown but periphery meltdown.
  • If one were looking for a sequence of events that might in retrospect mark out the path towards disaster, then Europe’s as-yet fruitless attempt at a collective economic response to the pandemic already has several milestones. There have been two Eurogroup meetings of finance ministers that have so far led to an endorsement of the existing European Stability Mechanism (ESM) with no proper elucidation of conditionality, a subsequent Council of Ministers (heads of state) meeting which has endorsed the Eurogroup’s non-decision, and a European Commission attempt to formulate a recovery fund which has already been downgraded (from fund to ‘initiative’) and even that announcement has been postponed this week. These can all be classed together as a failure of collective action
  • This is not to say there has not been action of sorts. Individual EU member states have announced a slew of fiscal policy initiatives. The problem is that the level of fiscal response is not equal nor even necessarily proportionate to the needs of each country. Italy has announced a number of initiatives (including a €750bn loan guarantee programme and a €55bn relief package currently making its way through parliament), but is highly constrained given its large stock of government debt (135% of GDP) and the risk the bond market takes fright at overly-large primary deficits. By contrast, Germany’s strong fiscal position has meant that it has announced policies which tally-up to just over half of the €1.9 trillion of policy initiatives announced so far in the whole EU. There is clearly growing inequality here, and inequality breeds resentment.
  • It is against this backdrop that the German Constitutional Court (GCC) based in Karlsruhe passed judgement on the ECB’s Public Sector Purchase Programme (PSPP) for European government bonds and also the European Court of Justice’s (ECJ) verdict on it. The ruling, which came out during market hours on the 5th May, effectively questioned the ‘proportionality’ of the PSPP with respect to the balance between the ECB’s responsibility for effecting monetary policy and the member state’s sovereignty with respect to ‘economic policy’. It found that in December 2018, the ECJ limited its judicial review allowing the ECB to ‘expand its competences on its own authority’.
  • The GCC’s own verdict on PSPP was that its size and duration showed the ECB to be ignoring the ‘proportionality’ between itself and the member states as the effects on economic policy were not properly assessed or established. While not declaring the PSPP itself to be ultra vires, the GCC nonetheless viewed that the ECJ’s attitude meant that safeguards against monetary financing of member states could not be guaranteed ‘in practice’, and that the Federal Government and Bundestag are required to ensure the ECB does a proportionality assessment. If this has not been completed within three months, “the Bundesbank may…no longer participate in the implementation and execution of the ECB decisions at issue”.
  • So what? The importance of Germany’s Bundesverfassungsgericht (Constitutional Court) and the Grundgesetz (Basic Law) it upholds can only be understood in the context of the country’s tortured history in the first half of the twentieth century. Avoiding a repeat of Nazi subversion of the law and the resulting sham legality of the rubber-stamping of legislation by the Reichstag was a cornerstone of the post-war settlement. A rules-based system upheld and enforced by the constitutional court lies at the heart of the German federal system.
  • The GCC holds jurisdiction over the Bundesbank, not the ECB. Previously, the GCC had deferred to the ECJ on rulings on quantitative easing (QE), but at this point it has effectively overruled the ECJ with respect to the scope and extent of the ECB’s powers and the Bundesbank’s execution of them. If the ECB does not ‘comply’ within three months, the GCC can effectively tell the Bundesbank to stop participating in QE. Would this be bad? Yes.
  • This is about limitation at a time when central banks elsewhere are ‘all-in’ with unlimited QE. Andrew Bailey, the new Governor of the Bank of England (BoE), for example said at the 7th May central bank press conference that there was currently no big distinction between BoE policy and open-ended QE. At the very least the European bond market needs to know that QE is ongoing; what it really needs to know is that its going to get bigger to mop-up the higher government bill issuance resulting from bigger government deficits. The GCC ruling mentions ‘high-risk government bonds’ – clearly this means Italy et al. The graph below shows the spread of 10-year Italian debt vs Germany. This spread was looking decidedly unhealthy even before the German ruling.

Source: Bloomberg, 7th May 2020

  • The GCC ruling only applies to the PSPP and not the newer, more flexible Pandemic Emergency Protection Programme (PEPP) belatedly launched in March by the ECB. This bond-purchasing programme can be used with discretion with respect to the normal purchase limits on individual member state’s bonds known as the capital key. The graph below (ECB data for March and April 2020) shows how PEPP policies have been heavily targeted towards Italy (and interestingly France). The widening in the 10yr Italy-Germany spread above must be considered in this context.

Source: European Central Bank, 30th April 2020

  • The ECB meeting on the 30th April singularly failed to deliver. There were some improvements to the central bank’s long-term funding programmes, but not the announcement of an up-sized PEPP that many either expected or thought necessary. In the context of the GCC ruling, more PEPP has to seem much less likely. The ECB is being hobbled at a time when its fellow central banks are going out guns a-blazing. As a consequence, as European government bill issuance at the short-end starts to ramp-up with higher issuance, a crowding-out effect of the private sector may start to manifest itself, directly undermining the ECB’s own efforts at helping the transmission of monetary policy.
  • What of the ECB itself? While not quite tabloid-style outrage, it is clear the board is not going to take this lying down. Former ECB Vice-Chairman Vitor Constancio tweeted an immediate response: “This is the big risk. New court cases will come immediately in Germany against PEPP. The Court insists in the ridiculous distinction between monetary policy and economic policy and wants proportionality in its effects. Can a German economist explain what this means?” Even better, the Financial Times quotes an (unnamed) current board member as questioning even whether they can respond, “What is the risk if we reply?” the council member asked. “When the time comes to raise interest rates, another court in a different country will challenge us — then what?” (ECB to resist German court order to justify bond purchases, FT, 07/05/2020).
  • But wait, that’s not all. Subsequent to the GCC ruling, the Governor of the Bank of France Francois Villeroy said it was likely the ECB has to go further to boost inflation. ECB Vice-Chairman Luis De Guindos said the ECB was prepared to recalibrate its instruments (it is unclear what this actually means, but it sounds like more not less). Finally, ECB President Christine Lagarde, fresh from her tetchy performance at the last ECB rate decision press conference, said on 7th May that the ECB is an independent institution (not in question), that it is accountable to the European Parliament (also not in question), and that it will do whatever is necessary to deliver on its mandate. (This mandate is delivering price stability, usually described as inflation of at or around 2% in the medium term. The graph below shows Euro 5y5y inflation – five year inflation in five years’ time. Lagarde had nothing to say on the ECB’s evident and consistent failure to meet its own target.)

Source: Bloomberg, 7th May 2020

  • The ECB’s official response following a meeting on the evening of the 6th May was, “The Governing Council remains fully committed to doing everything necessary within its mandate to ensure that inflation rises to levels consistent with its medium-term aim and that the monetary policy action taken in pursuit of the objective of maintaining price stability is transmitted to all parts of the economy and to all jurisdictions of the euro area.” (ECB Press Release 06/05/2020).
  • It looks like the ECB is digging in and may not even respond to the guys from Karlsruhe. There is a 3-month deadline. In the circumstances, it would seem difficult for the ECB to step-up the size, scope, or duration of its PEPP programme. Indeed, the German plaintiffs to the GCC, invigorated by their success, now plan to take on the PEPP: ‘“The court has stopped short of qualifying QE as monetary financing and has stressed the program’s limits are the reason for that,” said Bernd Lucke, one of 18 Germans who brought the case. “The ECB must now also incorporate them into the PEPP. If not, you could definitely sue again.”’ (German ECB Foes Focus on Next Battle: The Virus Rescue Plan, Bloomberg, 07/05/2020).
  • So much for the cast of central bankers. What about the rest? Italy seems restive, with criticism of Prime Minister Conte and even President Mattarella growing. There is talk of elections. The governor of Veneto, Luca Zaia, a member of Salvini’s League, is riding high in public opinion following the successful campaign against Covid-19 in the region. Even in the Italian political centre ground, a new and febrile euroscepticism is making itself felt. One cannot underestimate the psychological damage done with respect to Italy’s feeling for its fellow European countries when they reacted with indifference and even hostility when the virus erupted in Lombardy in February.
  • It is perhaps a sign of the times that the attempted enforcement of rules creating boundaries between monetary policy and fiscal policy causes outrage. A German court ruling on the ECJ and the ECB in the midst of the current crisis, especially with the big, Teutonic cheque-book being waved about within Germany’s own borders, might start looking to some like a Germany-First policy. Given the rise of popular politics across Europe and in the context of Europe’s half-formed polity of monetary union without its usual fiscal twin, it is decidedly dangerous. A horse that falls at every fence tends to end up in the knacker’s yard.

Unless otherwise stated, all opinions within this document are those of the RWC Diversified Return Investment Team, as at 7th May 202.

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Thoughts through the cycle: W1 May ’20

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