ECB BROADENS ITS STIMULUS PACKAGE
As expected, the ECB cut its deposit rate further into negative territory, but in a surprise move, the rate on the main refinancing operations, which normally provide the bulk of liquidity to banks, was reduced to zero. The rate on the marginal lending facility was also cut. Monthly asset purchases are increased to EUR 80 billion. To ensure enough bonds are available for purchase, the ECB will now also buy investment-grade, non-financial euro corporate bonds.
In our view, these measures show how the persistent undershooting of the targeted path of inflation has pressured it to take far-reaching action. Eurozone inflation has been so far below the ECB objective for so long that the target has lost credibility. Looking at the ECB’s projection of only 1.6% for inflation in 2018, we believe the ECB will struggle to hit that target not just in 2018, but beyond. Further action looks likely, but only in the second half of 2016 at the earliest.1
BOJ ON HOLD FOR NOW, AS IS THE FED
The Bank of Japan left rates unchanged. However, as leading indicators have all softened lately, the economy may be weak enough for further stimulus. Even with low unemployment, wage growth is virtually non-existent and core inflation slowed slightly in January. GDP contracted in the fourth quarter and further contraction early this year should not be ruled out.
Markets had expected the Fed to leave rates unchanged, as it did, and instead focused on what might happen later this year given the weakness in the US economy over the turn of the year and better recent data such as February’s labour market report. While retail sales fell in February for the second straight month, we don’t think this means consumers have thrown in the towel. Confidence may have stalled, but income gains are robust and labour market developments are more in line with ongoing gains than with deceleration. Household finances have improved and levels of savings mean consumers can pay off debt or boost assets.
So what did the Fed have to say about this? At their latest rate-setting meeting, policymakers lowered their forecasts for an increase this year. And with the soft patch in growth, the Fed also had to cut its forecasts. In its growth assessment, the Fed referred to a moderate pace despite global economic and financial developments. Those developments still pose downside risks, according to the Fed. Household spending and the housing and labour markets remain bright spots, with business investment and exports seen as soft.
Shifts in individual policymaker forecasts should be interpreted with caution as the composition of the FOMC policy committee has changed from December, when the previous projections were released. While the median forecast for the fed funds rate at the end of this year fell by 50bp to 0.875% (see chart below), indicating only two rate hikes, one dissenter favoured an increase already at the latest meeting. We think market participants had expected the Fed to be less dovish, discounting 75bp in hikes still this year. Thus, bond yields fell, equities gained and the US dollar depreciated versus the euro.
All in all, the Fed’s tone, the downward revisions of growth, inflation and interest-rate projections as well as Fed chair Yellen’s comments should not meaningfully change market expectations, even though the Fed sounded more dovish than expected.
MORE DISAPPOINTING DATA FROM CHINA
Last week, we concluded that China’s 6.5%-7% GDP growth target may not only be a challenge, but could also result in overstimulation and bigger imbalances. Recent data has confirmed this view. Retail sales grew at the slowest pace since 2004. Annual growth of passenger car sales plunged back into negative territory. Industrial production growth fell to not far above the low in the 2008/09 global recession. The dip in credit growth looks less worrying since such growth was (and still is) too strong and the slippage followed a surge in January.
The economy has not shown any rebound other than in home sales and house prices. However, given large inventories of unsold homes and projects under construction, this may not lead to additional construction for some time yet.
ASSET ALLOCATION: UNDERWEIGHT EMERGING MARKET DEBT IN HARD CURRENCY
In our core asset allocation, we are now underweight emerging market (EM) debt in hard currency, i.e. the EMBI index versus US Treasuries, as we expect spreads on these bonds to widen. We are structurally cautious on EM economies, given the outlook for desynchronised growth and no indication of a pick-up from indicators such as PMIs, industrial production or exports. The recent bounce in commodity prices helped to push EM assets higher, but looking at supply and demand balances, this may have come too early and gone too far. In fact, our commodity outlook points to renewed price pressures for the next couple of months.
Cross-asset valuation shows that equities and currencies account for a large part of emerging market negativity. EM equities corrected by less than developed equities in January and a growing number of central banks in emerging economies have started to comment on currency weakness. Spreads on EM bonds appear not to discount the poor outlook. Unlike in developed markets, we have not seen a blow-out in corporate debt spreads since most energy companies are government-backed. This could add pressure on sovereigns’ solvency. In this context, the recent rating downgrades look like only the start of a longer trend of downward revisions.
1 See also our flash note ECB: trying the big bang
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