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Thematics Views - March 2020



Should Central Banks save us from ourselves?

Coronavirus and Italy’s vulnerability

The repricing of credit risk


March 2020


Mars 2020

Auteur 1

Should Central Banks save us from ourselves?

From unemployment and inflation to climate change and social inequality, central banks (CB) are on the frontlines. In the context of the ECB’s and the Federal Reserve’s strategic reviews there are now open debates about their new tools, targets and mandates. But a more profound change in central banks’ behaviour should also be discussed, regarding recession aversion, fiscal dependence and markets interaction.

Central banks have become recession-adverse

Over the past decades, CBs have mainly been re-active to external shocks and significant accelerations or slowdowns affecting the economy. They have carefully dealt with the normal phasing of the economic cycle as a natural adjustment, in a sort of cyclical neutrality. Hence, the common view that central banks are “behind the curve” i.e. financial markets are adjusting faster than monetary policy.

But 2018-19 shows a different picture. Major central banks have pro-actively changed their policies without hard evidence of an economic slowdown, as if they were trying to erase the risk before the fact. This recession aversion is different from the implicit “Fed put” often discussed by market participants and researchers as an ultimate safety net for investors in phases of significant turmoil. Both Fed and ECB policies intended to prevent a negative phase of the economic cycle. This behaviour has surprised investors, hence the stellar performances across asset classes in the second half of last year.

Why is it so important to avoid a recession?

The first explanation is that the global economy is still fragile, and a traditional cyclical slowdown could cause significant damage. Many countries that did not improve their economic resilience through structural reforms and public debt reductions might struggle in a recession if the bond market questioned their debt sustainability. In a context of rising populism, a wait-and-see attitude can therefore be dangerous. Secondly, central banks might simply be short of ammunitions to deal with a recession, and therefore need to stop the disease as soon as the early symptoms appear. These good reasons emphasize CBs’ cyclical dependency.

To be fully comprehensive,
Central Banks reviews need to reassess their independence

Fiscalisation of monetary policy

Another important change is the link between fiscal and monetary policy. According to textbooks, monetary policy is a short-term fix in reaction to an economic shock (such as Covid-19) or to a pronounced slowdown of the economy, before fiscal policy kicks in to restore the growth path. Monetary policy can be implemented in a timely and technocratic manner while fiscal policy requires political support. The independent central bank pursues inflation targeting and carefully avoids long-term imbalances. We know that, in reality, things are more complex. But still, this has been the intellectual framework among advanced economies. Now Christine Lagarde is calling for more support from euro-area countries with budget surpluses.

Although a closer coordination of fiscal and monetary policy looks reasonable, the new mantra is fiscalisation of monetary policy. There is a difference between coordination and condition, just as there is a difference between correlation and causality. Though coordination is needed, if monetary policy becomes a condition of fiscal policy then it undermines CBs’ independence. Moreover, in an economy where debt to GDP is close to 100%, interest rates are below 1%, taxes account for 40% of GDP, and the central bank is buying 60% of net government debt issuance, the difference between fiscalisation of monetary policy and monetization of fiscal policy is only semantic. The risk is therefore a loss of credibility in an attempt to support economic growth.

Market and CB reflexivity

Like never before, investors’ behaviour and asset classes’ movements have become a direct function of central bank decisions, as well as a measure of success of their policies. QE and negative interest rates have significant implications for financial markets, as they erase the need for, and therefore the value of, hedging strategies, while lowering risk premia and artificially increasing diversification. Yet, central banks’ influence on wide range of financial instruments leads to a form of Hegelian master-slave dialectic at the expense of their independence. As they try to protect investors and states, CBs become market-dependent.

To be fully comprehensive, the CB strategic reviews need to take these developments into account. While central banks are trying to save us from ourselves, they undermine their own credibility in a form of triple dependence on the economic cycle, fiscal policy and financial markets.

Tableau 1

Finalised on 26/02/2020

Auteur 2

Coronavirus and Italy’s vulnerability

A deep dive: from local impact to national implications

We leverage data from the Italian statistics offce (ISTAT) at a regional and provincial level to put the possible impact of the virus outbreak on economic growth into perspective. With considerable uncertainty about how long the crisis will last, as of now, a zero-growth scenario this year already seems on the cards.

Over the past week, several cases of coronavirus have been confirmed in key production and tourism districts of northern Italy, quickly raising concerns of a recession risk. Time is a key factor: broad implications will depend on the duration of emergency measures and on the most acute phase of the crisis. A quick return to business as usual may limit the impact to Q1 and facilitate a quick rebound in Q2, limiting the impact on the Italian economy. Also, any better-than-expected developments on the external front might temper the negative impact on domestic demand. Yet, risks remain skewed to the downside.

In a recent interview, the Bank of Italy Governor said that 0.2% of GDP is at stake. Assuming this as a fair estimate of the shock and that it is concentrated in Q1, the stress would likely imply a significant contraction in Q1 (-0.6% QoQ), hence a technical recession (after -0.3% QoQ in Q4 2019), and would bring growth to zero in 2020 (if we assumed a significant rebound in Q2 and an average growth rate of 0.2% QoQ for H2 2020). In the absence of V-shaped rebound, growth could well move to -0.6%YoY in 2020.

Far from any attempt at being exhaustive, we put in perspective the extent of damage, while focusing on two direct channels of domestic stress (loss in consumption and production), trying to find possible “benchmark” scenarios in line with the level of stress described above.

Impact via stress on consumer behaviour: Assuming considerable stress, i.e. that for four weeks three categories in particular of consumption (transport, clothing and footwear, hotels and restaurants, which we assume to have a weight on regional consumption equal to the national one) halve in those regions (Lombardy, Veneto, and Emilia Romagna, which account for 37% of final consumption expenditure of resident and non-resident families and up to 32.2% of the total Italian population, i.e. more than 19.4 million people) the impact is approximately between €4.2 billion and €4.5 billion. It is clearly a significantly stressed combination of factors, in terms of breadth (regional level and not the town/area level), duration (four weeks) and impact (halving consumption in selected categories with no offsetting factors). By attributing this impact totally to the first quarter (but allowing payback in Q2), 2020 GDP projections move to below -0.1% YoY. By relaxing the assumptions either on the duration of the stress (two weeks) or geographical extent (only selected provinces), the effects are clearly reduced so that growth projections come back in line with a 0% GDP growth in 2020 if the Q2 payback effect is allowed. Indeed, on the one hand, several factors could mitigate the estimated impact, considering that other spending may partly offset the decrease in the selected categories (e.g. for disinfectants, personal care, online sales vs retail sales); on the other hand, some consumption can be assumed to be gone forever (restaurants, travels etc) with little payback effect to be considered. At the same time, while areas affected are limited in extent, irrational behaviour could heighten risk perception and severely impact consumer confidence not only in the regions affected but also at the national level, amplifying the effects.

We evaluate two direct channels of domestic stress, consumer and production

Graph page 2

Little visibility, yet stagnating growth (at best) very likely

Impact via the production channel: Lombardy, Emilia Romagna and Veneto account for around 40% of Italian GDP. At this stage, the implied regional impact is enormous. Assuming that services and manufacturing work at 70% for two weeks, the impact would be around negative €7 billion. GDP growth would decline to -0.3% YoY in 2020, (allowing for payback in Q2). Assuming only a few provinces are affected (Milan, Cremona, Lodi, Padua, Piacenza, for instance) at 50% capacity, then the impact would move GDP growth to 0% YoY in 2020, allowing for payback in Q2. Reports from those areas and companies do not point to a shutdown of activities of this sort. Yet, looking at energy consumption, at a national level energy consumption on Monday, 24 February was 6.6% below the weekly average, and on Tuesday the 25th 2% lower, which could point to a normalisation impact on the production front already taking place.

Data are available at regional or province levels. On that basis, we simulate scenarios where the areas involved are much broader than the actual areas shut down or where significant limitations are in place.

Although not necessarily realistic, this exercise may be helpful for putting the numbers and the risks in context. We already expected the Italian economy to grow by a meagre 0.2% YoY this year, supported by weak but positive growth in domestic demand and international trade, with high vulnerability to external and internal shocks. Recent developments put this projection at high risk, with the downside scenario projection of GDP growth down to -0.5% YoY (or less) becoming not unlikely, should an extension of the domestic stress limit the extension of payback effects in Q2, or external demand deteriorates further (or a combination of both). Indeed, the stress will work though interacting factors that are diffcult to estimate in advance and perhaps focused on selected sectors. For instance, the impact on tourism is estimated to be significant for H1 at least, but may also significantly affect the summer period. According to Bank of Italy, in 2017, activities directly attributable to tourism account for more than 5% of GDP and 6% of employment.

Graph page 3

Finalised on 27/02/2020

Auteur 4

The repricing of credit risk

Markets are now questioning the assumption of world growth stabilization. Before the sell-off, corporate debt market was driven by liquidity/search for yields without worrying about fundamentals: huge inflows, very active primary market, and tight valuation. This risk-off market moves could penalize global growth, especially given how late we are in the cycle.

In 2019, we switched from low interest rates to ultra-low interest rates for longer with central bank liquidity injections

The global economy entered a synchronized slowdown. Global growth was downgraded to 3%, its lowest rate since 2008. The weakness in growth was driven by a sharp deterioration in global manufacturing activity to levels not seen since the financial crisis, on the back of rising trade and geopolitical tensions, the slowdown of the Chinese economy, and a slump in the auto industry. Domestic demand in developed economies remained solid, supported by strong employment gains and the expansion of the service sector.

The world’s major central banks returned to an easing stance, due to weak global growth and muted inflation. In particular:

  • The Federal Reserve made a sharp U-turn in the path of its monetary policy in January of last year, ultimately cutting its key rate three times in 2019, compared with its previous own forecast of three hikes. FOMC members consider these cuts as “insurance cuts”, as the US economy is driven by solid consumer spending but threatened by global weakness, the US-China tariff war and Brexit uncertainties.
  • The European Central Bank delivered a full package, cut its deposit rate by 10bp to minus 0.5% and restarted its asset purchase program in November. The size is modest (€20bn per month) but the program is open-ended and would last “as long as necessary”.

All in all, negative yields have become the new norm after central bank policy and weak growth prospects led to a huge bond rally. The global pool of negative-yielding bonds has jumped to more than $15 trillion. The vast majority of bonds in Europe and Japan carry negative yields to maturity. In the euro fixed-income space, debt in negative yield rose back to 55% by the end of January, after falling to 45% by end December 2019. Italy, BBB corporates and HY account for almost all available yields above 1%.

The credit market has become addicted to liquidity

The credit market has become addicted to liquidity

Before coronavirus concerns hit the markets, fixed-income investors were looking for a strategy to generate income in a world of low or negative interest rates. The result was:

  • Huge inflows into the corporate bond market. The growth and persistence of negative yielding debt has pushed investors into taking more risks.
  • Intense activity on the corporate debt primary markets. Strong demand easily absorbed this new supply and the order books were often spectacular. On Euro IG market, 2019 volumes reached decade-high levels with huge activity in BBB-rated issuers, long maturities and US-domiciled issuers.
  • Tightening in IG and strong compression in HY. Investors’ demand for spread products pushed spreads and volatility lower and flattened spread curves. In particular, the yields offered by US B-rated issuers reached an all-time low of 4.9% in early February.
Graph page 4

Ultra-accommodative monetary policy stretched the credit cycle, but it has not disappeared

Because of this environment, corporate default rates were below long-term average despite heavy leverage of some issuers and weak earnings growth. As long as a company can refinance its debt at advantageous rates, it does not default. In other words, default rates projections are lagging behind current market conditions!

The assumption of global growth stabilisation is now challenged by the coronavirus crisis

Before the coronavirus, the scenario for 2020 priced in by the markets was a stabilisation in global growth as trade tensions and monetary policy eased. In light of the very low/negative returns on offer on sovereign core bond markets, this backdrop would have been favorable for risky assets despite tight valuations.

The assumption of a stabilisation of world growth is questioned today by the markets. The health crisis has the potential to shock the economy via direct impacts (lower tourism, lower goods exports and global supply chain disruption) and indirect impacts (tightening in financing conditions).

Going forward, we have no doubts on central bank willingness to keep a dovish bias. This unprecedented landscape of “negative yields combined with central bank purchases” is unlikely to change substantially soon. Nevertheless, investors could pay more attention to fundamentals and it is difficult at this stage to assess the magnitude of the damage the virus will do to the economy.


The risk is a jump in corporate default rate and wave of BBB downgrade

Corporate fundamentals are at the center of the game. The coronavirus could have a significant impact on companies via:

  • A tightening in financing conditions. In recent days, growing fears about global growth have caused market volatility and risk premiums on bonds to rise. The coronavirus stopped the euphoria of the primary corporate bond market. The risk is that the market will close for an extended period.
  • Earnings pressure. If the coronavirus is not contained quickly, it will affect earnings significantly. It is worth noting that earnings growth was already weak even before the coronavirus. The energy, automotive and tourism sectors will be particularly affected by this health crisis. 

This could lead to an increase in:

  • Downgrades. The riskier environment could encourage rating agencies to downgrade high-leverage US BBB issuers (50% of US IG).
  • Defaults. Increase in risk aversion and sluggish earning growth is a big threat to low-rated HY companies. Indeed, interest coverage is more closely related to earnings than to interest expense, as interest coverage could be quickly eroded by a hit to earnings.

The shock could possibly prove stronger in the short term, but we are sticking with the view that the situation will stabilize at some point in the coming months, leading to a catch-up thereafter.

Additional support from central banks and governments to fight any further deterioration in the economic outlook is a key assumption regarding this view. Nevertheless, we have to remain vigilant, accommodative monetary policies are stretching the credit cycle but it has not disappeared. Sustained risk-off market or a significant risk premium adjustment by the markets could seriously penalize global growth, especially given how late we are in the cycle.

Finalised on 27/02/2020

BOROWSKI Didier , Head of Global Views
BLANCHET Pierre , Head of Investment Intelligence
USARDI Annalisa , Senior Economist
AINOUZ Valentine , Deputy Head of Developed Markets Strategy Research
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Thematics Views - March 2020
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