Eurozone QE: Mind the output gap

  • Eurozone output gap is highly correlated with core inflation
  • Slowing money circulation means QE is “pushing on a string”
  • Eurozone consumers unlikely to benefit from wealth effect

26 January 2014, London. Paul Marson, Chief Investment Officer at MONOGRAM Investment, comments on the correlation between the output gap and Eurozone core inflation, and how the benefits of QE will be offset by slowing money circulation:

How effective will the new Eurozone QE be? Eurozone core inflation [the ECB has no control over food and energy prices] is highly correlated with the output gap [gap between actual GDP and potential GDP]. Therefore, to increase inflation (and avoid deflation), you have to increase GDP growth and close the output gap.

Graph 1: Eurozone Output Gap v Eurozone Core inflation

26.1.2015 Eurozone QE Graph 1

However, QE is unlikely to close the output gap because for every 1% increase in the Money Supply from the ECB, there is an approximate 1% decline in the velocity of circulation of that money.  Put simply, Eurozone QE puts more money into the system but it circulates more slowly.  The net effect is that nothing changes. It really is pushing on a piece of string. 

Graph 2: Correlation between % change in Eurozone monetary base and % change in monetary base velocity

26.1.2015 Eurozone QE Graph 2

So the real hope of QE seems to be that an increased monetary base will lead to higher asset prices (especially in equities), and people will feel wealthier and spend more.  The trouble is, consumers in Japan and Eurozone have low holdings of equities (unlike the US and UK) and hence are unlikely to benefit from a wealth effect.

Euro QE finally launches but likely to be “Damp Squib”

  • QE in UK and US have failed to stoke consumer demand inflation
  • China continues to export deflation into the Eurozone
  • QE not likely to translate to increased private sector loans

London, 22 January 2015. In response to the European Central Bank’s (ECB) announcement of quantitative easing today, Paul Marson, Chief Investment Officer of MONOGRAM, argues the programme is unlikely to work:

The question is why the biggest private sector credit boom in history – prior to the financial crisis – did not generate consumer price inflation: at the start of the crisis, core inflation was just 2% in Europe and the US. The answer to this is crucial, and explains why quantitative easing in the US/UK has raised asset prices – but not consumer inflation – and why euro QE is likely to be unsuccessful in achieving the ECB’s inflation objective.

Graph 1: UK core inflation and five year annualised inflation following QE

26.1.2015 Damp Squib Graph 1

“That underlying core inflation rates in the US and UK are lower today than when QE started is due to tide of disinflation originating from China. Chinese manufacturing goods supply is growing much faster than Western and Chinese demand for manufactured goods. This means a glut of supply which increasingly pushes down manufactured goods prices. Since China accounts for 17.1% of the total increase in world merchandise export (excluding the Eurozone) from 2002-2012, it is increasingly exporting deflation. Inflation is low, and getting lower, because the world is awash with supply – a “positive supply shock” is more powerful than the modest “positive demand shock” coming from QE.

Graph 2: Chinese manufacturing sector supply/Western demand mismatch

26.1.2015 Damp Squib Graph 2

“The problem confronting the ECB is that peripheral banks have substantially increased their holdings of [non-productive] government debt and substantially reduced (productive) loans to the private sector, amidst ongoing balance sheet shrinkage: the ECB hopes to take those bond holdings down and encourage private lending, a policy that is unlikely to have meaningful effects from exceptionally low current bond yield levels. It is more likely that bonds will replace the bonds they sold with more government bonds!”

Graph 3: Change in PIIGS MFI Assets from 2008

26.1.2015 Damp Squib Graph 3

Swiss Franc Surge: “Canary in the coalmine” shows dark clouds ahead

• Australian dollar/Swiss Franc cross rate is strongly correlated with FTSE 100 performance
• Current disconnect indicates a cause for concern for equities

16 January 2015. Following the recent Swiss Franc surge, Paul Marson, chief investment officer at MONOGRAM, comments on the possible implications for UK equities:

“The performance of the cross rate between the Swiss Franc and Australian Dollar is closely correlated with the FTSE 100 performance (see Graph 1 below).

“There is a logical explanation behind this. The Australian Dollar is driven by demand for primary resources, which in turn is driven by global demand growth and, in particular, manufacturing in Asia – hence it does well during periods of strong economic growth. The Swiss Franc, on the other hand, tends to strengthen during periods of economic weakness, credit stress, uncertainty or loss of risk-taking appetite.

“This makes the cross rate of the Australian Dollar/Swissy a “canary in the coalmine”: a leading indicator of a weak or strong equity outlook for the UK FTSE. Recently, a significant disconnect between this rate and the UK FTSE has occurred (see Graph 2 below).

“This, which was further magnified by the Swiss Franc surge, is cause for concern and merits a more cautious approach to UK equities.”

Graph 1: Australian Dollar/Swiss Franc exchange rate vs six month % change in FTSE Index

19.01.2015 Swiss France Surge Graph 1

Graph 2: Australian Dollar/Swiss Franc exchange rate v UK FTSE index

19.01.2015 Swiss France Surge Graph 2

 

Swiss Franc Surge: Do They Know Something We Don’t?

• Franc rise will have massive impact on exports of goods and services which are 66% of Swiss GDP and imports which are 52% of GDP
• Could this be a sign of impending euro quantitative easing on an exceptional scale?

London, 13 January 2015. Paul Marson, chief investment officer of MONOGRAM, comments on the Swiss central bank’s surprise announcement that it has abandoned its currency peg with the euro:
“Today’s announcement is puzzling. Switzerland’s economic situation isn’t that different from September 11, when the peg was bought in to stave off deflation. Core inflation is 0.3% today, and was 0.2% in 2011. Arguably there may be greater demand for Swiss francs from capital flight from Russia, but such a currency rise will have a big impact on Swiss growth and inflation and on company earnings [Swiss companies will largely not have hedged currency exposure, in expectation of a continuing cap].

“With imports 52% of GDP and exports 66% of GDP, the currency really matters in Switzerland – and this will really damage Swiss exporters. Import prices will weaken, once again raising the spectre of deflation and growth is likely to weaken: the very same concerns that the Swiss National Bank (“SNB”) raised in 2011 would appear to apply today.

“Maybe the SNB knows something we don’t? One explanation is the possibility of euro QE on a greater than anticipated scale, perhaps the SNB decided not to fight the ECB and is unwilling to see a further substantial balance sheet expansion (and suffer the practical difficulties that coincide with the eventual unwinding of those positions)? Perhaps ECB quantitative easing has forced the SNB to throw in the towel after a CHF 307 bn (398%) increase in the monetary base since mid-2011? After all that balance sheet expansion, the CHF is stronger, growth little better and deflation risks almost identical: one has to wonder, was it worth it?”

Swiss Franc/ Euro Exchange rate

15.1.2015 Swiss Franc per Euro

UK Inflation: Long Term Structural Pressure from China, but Recent Falls are Driven by Oil Price

  • 8% fall in energy CPI; excluding food and energy CPI is 1.3%, down from 1.8% in January 2014
  • Structural mismatch between Chinese manufacturing investment and Western demand means China is “exporting” deflation into the Eurozone

London, 13 January 2015. Paul Marson, Chief Investment Officer of Monogram, comments on today’s inflation figures and the root causes:

“Today’s figures reflect a sharp 5.8% fall in energy CPI over the past year.  Without the impact of oil prices on food and energy, underlying CPI remains a more plausible 1.3% year on year, up from 1.2% year on year in November.

“In the long term, the UK faces the structural pressure of Chinese “exported deflation”. China’s manufacturing goods supply is growing much faster than Western and Chinese demand for manufactured goods. This means a glut of supply pushing down manufactured goods prices and western inflation in general.

China is a global price setter and its proportion of exports to the UK has grown significantly over the past decade, meaning that China will increasingly export deflation to the UK and the West.”

Graph: UK Energy CPI

 13.01.2015 UK Inflation Graph 1

Graph: Chinese manufacturing sector supply/ Western demand mismatch

13.01.2015 UK Inflation Graph 2

“Made in China”: The Hidden Cause of Euro Deflation

  • 13% of non-internal Eurozone imports are from China
  • Structural mismatch between Chinese manufacturing investment and Western demand means China is “exporting” deflation into the Eurozone

London, 8 January 2015. The Eurozone officially entered deflation this week, driven by falling oil prices. Paul Marson, Chief Investment Officer of Monogram, comments on the more concerning long-term structural driver of Eurozone deflation:

While ‘Made in China’ is a common sight on manufactured goods, China also exports deflation. Chinese manufacturing goods supply is growing much faster than Western and Chinese demand for manufactured goods. This means a glut of supply which increasingly pushes down manufactured goods prices.

According to World Trade Organisation data, China accounts for 17.1% of the total increase in world merchandise export (excluding the Eurozone) from 2002-2012, hugely disproportionate to its size. This makes China a global price setter. In the past decade, the percentage of Chinese imports into the Eurozone has doubled, meaning that China is increasingly exporting deflation into the Eurozone.

Worryingly, Chinese monetary stimulus, which looks likely, will increase Chinese manufacturing investment, further exacerbating the problem.

Graph: Chinese manufacturing sector supply/ Western demand mismatch

08.01.2015 Eurozone Deflation