Negative interest rates, reflection and remedy of excess pessimism in Europe – Dorval’s Macro Corner (September 2019)

"Adapting economic knowledge to market realities and breaking free from the tyranny of indices"
François-Xavier Chauchat
Member of the Investment Committee. Macroeconomic framework and asset allocation.
While the US economy continues to obsess most investors, some observers believe that the biggest risk lies in Europe, as evidenced by the black hole of negative rates.

It is in Europe that growth forecasts have been downgraded the most over the last year, and recession is threatening in Germany and Italy. There are serious concerns about German fiscal sadomasochism, and the cost-benefit ratio of further monetary easing. In addition, the friction costs of the energy transition weigh heavily on growth, with a "green recession" in the automotive sector. Finally, the economic risks associated with Brexit are still to come.
These concerns are valid, but they are probably exaggerated. Firstly, the most domestic part of the economy—consumption, construction & real estate services—continues to hold up well. Secondly, the beneficial effects of the collapse of interest rates must not be underestimated. Amounting to nearly 2% of GDP, interest charges on public debt could almost disappear within five years, which would leave substantial fiscal space for the euro area countries. This fiscal stimulus by stealth is admittedly gradual, but it is far from insignificant.
The implications of super-low interest rates will be particularly powerful in Italy, where the public debt burden amounts to 3.6% of GDP. With Italian bond yields close to zero, Giuseppe Conte’s new pro-European government will regain some room for maneuver. Moreover, the action of the ECB, which will soon be strengthened, has already produced a domestic reflation in the peninsula, as can be seen in real estate. One of the major sources of European risk is therefore drying up.
Finally, negative rates have raised more and more support, including in Germany, in favor of a European investment plan in the green economy, which would materialize in 2020. We remain cautious, but a "green" plan could provide a pro-growth impulse to a societal trend that tends to penalize it, at least in the short term. In this respect, a more realistic transition to the electric car would bring some welcome relief.
The risk of a no-deal Brexit still remains, a scenario that would plunge the United Kingdom into depression, and weigh on all Europe. A no-deal Brexit remains an unlikely scenario because it involves chaos that is of no political gain for anyone. All that is needed for an agreement to be reached is progress on the Irish border, which is the only real stumbling block—after or before new elections. 
Given the strong pessimism reflected by German bond yields, and by surveys of European investors, a grey but not black scenario for Europe could be enough to reassure. Markets, indeed, are often moved by developments “at the margin”. One could then hope for renewed interest in the small caps universe, which has suffered for a year even though it holds profit leadership in Europe. In the meantime, we maintain a highly diversified and conservative approach in our international flexible portfolios, with equity exposure close to normal but hedged with US bonds. However, we have taken some options to buy European cyclical and banking stocks to position on an easing in excessive pessimism. We have also begun to take profits on Italian bonds.


Download Dorval’s Macro Corner of September 2019 in PDF version here


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