Reiterating its cautious position on Europe, Pimco said ECB needed to assess the trade-off between ultra-loose policy and high unemployment and the unintended consequences of tapering its quantitative easing (QE) programme.
Andrew Bosomworth, managing director and portfolio manager at Pimco, said easing off QE would be tricky, with the bank unlikely to remove its stimulus until inflation was on solid track towards 2%.
“The European Central Bank’s enormous stimulus has strengthened eurozone financial markets’ resiliency, but it has also made them dependent on ongoing stimulus to maintain stability.
“Weaning markets off easy monetary policy will be a delicate exercise for the ECB and is a topic we think will gain prominence next year – and one that reinforces our long-term caution about investing in the eurozone.”
He said the ECB saved the euro in 2012 by acting as “lender of last resort” to its sovereign shareholders.
In turn the European stability mechanism (ESM) being put in place to support eurozone countries in financial difficulty laid the foundations of a banking “union”.
Now the eurozone crisis has calmed down, and the ECB is refocusing on price stability, Bosomworth thinks things will ease again – following five years of low price increases and inflation lagging targets.
“We think the package of measures will include an extension of QE by six to nine months at the existing purchase rate of €80 billion per month, bringing asset purchases to 20-23% of GDP.”
He said any extension of QE would require the ECB to relax some of its current rules for purchasing government bonds.
Currently these include bond yields at or above the deposit facility rate of -0.4%, geographical distribution of purchases in line with the ECB’s capital key, and purchases to not exceed 33% for any one bond or issuer.
Pimco highlights two outcomes of a QE tapering programme – spare capacity or no spare capacity.
In the former, the unintended costs of loose monetary policy begin to outweigh the benefits, prompting the ECB to wind down QE.
“The risk for investors is that stopping QE while growth remains sluggish could cause bond yields to rise to levels that rekindle concerns about debt sustainability – especially for countries with high debt burdens and low rates of economic growth,” he said.
He gives the example of Italy, where economic growth is low, and economic reforms are desperately needed.
“Nominal GDP growth has averaged just 0.2% annually since 2009, and current growth owes largely to easy monetary conditions.
“[Also], Italy is too big for the ESM to rescue. The government’s ability to reform, which the upcoming constitutional referendum will test, is an important determinant of how Italian assets might perform when the ECB exits.”
In the second scenario – no spare capacity – actual growth rises to potential, closing the output gap.
This is “exactly what the ECB aims for” and enables it to exit, he said.
“What concerns us here is the sustainability of the southern European countries’ current account balances. This region started on the euro with a small current account deficit and just over 11% unemployment.
“During the boom leading up to the financial crisis, unemployment fell to 7% and the current account deficit widened to 7% of GDP. Foreign capital, which financed the current account deficit, fled during the crisis, causing growth to collapse and the current account to eventually swing nine percentage points of GDP back to a 2% surplus – but at the cost of 16% unemployment.”
He explained if these countries were somehow to regain full employment, it was possible that their current accounts would move into deficit and therefore investors had to consider their risk exposure.
“Both scenarios are extreme. And while we think the first better describes the economic landscape ahead, the ECB is unlikely to remove its stimulus until inflation is solidly on track to 2%. We view tapering, therefore, as a topic for 2017 and beyond.”
