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Huw Pill (Goldman Sachs): QE will be extended through the end of 2018, the risks and opportunities for investors


Huw Pill, Goldman Sachs Chief European economist and co-head of the Economics team in Europe, talks about the prospects of 2018 regarding the economy, the ECBs QE program, the risks and opportunities for investors, the Italian election and Brexit, in an exclusive interview with and Eleftheria Kourtali.



Q: Euro area growth has surprised to the upside over the course of 2017, beating US growth, while inflation remains stubbornly low. Will this trend continue in 2018, what are the upside and downside risks?


While the acceleration of activity in the Euro area is now largely behind us, we expect continued robust growth at a year-on-year rate slightly above 2% in 2018. The strong momentum achieved over recent quarters is set to continue through the turn of the year, supported by external demand and a revival of consumer spending within the Euro area itself. Area-wide unemployment will continue to fall, as the labour market slack created by the Great Recession is re-absorbed. Although the pace of Euro area growth is set to weaken in the second half of 2018, we think it will nonetheless remain well above trend for several years yet.


Despite this sustained expansion, we foresee Euro area inflation remaining stubbornly below the ECB’s 2% target. In many of the peripheral economies, inflation weakness owes to still high (although falling) unemployment and remaining slack in the economy. But low inflation is harder to explain in Germany, where growth is well in excess of trend and unemployment has already fallen to 3½% -- a very low level by recent historical standards. We attribute weak German inflation to the disciplining effect of globalisation: the inflow of workers from central Europe serves to cap wage growth in the German services sector, while German manufacturers serving global markets insist on wage moderation from their employees and their unions if jobs are to be kept in Germany rather than sent abroad via offshoring.


Since these global forces are unlikely to diminish anytime soon, we forecast weak German – and thus Euro area – inflation in the coming years. As ECB President Draghi has said repeatedly, while we can be confident that the threat of outright deflation has been overcome and the prospect of higher inflation exists while the robust recovery continues, patience is needed regarding the return of inflation to its 2% target.


Q: The ECB lowered QE but kept it open-ended. Will asset purchases stop in September or do you expect an extension of the program? How far is the interest rate increase? What risks does this highly accommodative policy pose to the financial system and asset (bond/equity) markets, as well as the euro


We expect the ECB to continue purchasing assets through the end of 2018, implying an additional modest extension of the programme beyond what has already been announced. But we see the direct impact of these purchases on the Euro area economy as now rather modest. The ECB has already satiated the market’s demand for liquidity, squeezing term and risk premia to low levels. At this point, the longevity of the asset purchase programme is mainly a signal about the outlook for interest rates.


In our view, the ECB remains committed to only raising its policy rates “well past” the date asset purchases cease. By extending the QE programme to end-2018, this pushes expectations of the first rate hike well into 2019. The market is currently pricing a first policy rate increase in the late spring of that year, and Mr. Draghi appears comfortable at present with that view. Given the stubbornly below target area-wide inflation rate and prospect of some easing of Euro area growth in the second half of next year, we anticipate a first hike to come slightly later, in the second half of 2019. But the risks around that view are skewed towards an earlier hike. At this stage, we also view current market expectations as broadly appropriate.


Following the lead of the Anglo-Saxon central banks, we anticipate that any normalisation of ECB policy rates will be gradual and limited. Rates are likely to settle at lower levels than we observed prior to the crisis. Wider spreads owing to stronger financial regulation imply that market rates (and thus broader financial conditions facing households and firms in the real economy) will be higher relative to the policy rate than in the past. Moreover, the underlying equilibrium interest rate in the economy is probably lower than before the crisis, as trend growth is weaker.


The ultra-accommodative monetary policy delivered by the ECB in response to the financial, sovereign and banking crises of recent years has served to bid up asset prices to elevated levels. The risk exists that once this policy support starts to be withdrawn a sharp correction in asset prices could occur. The slow, gradual and limited approach to policy normalisation we anticipate from the ECB represents an attempt to manage this process and achieve a “soft landing”. Doing so is a tall order. We do expect the Euro to strengthen slightly against the US Dollar over the coming year, but – at a time when monetary policy normalisation is much further advanced in the United States than in the Euro area – this owes more to better economic and political prospects on this side of the Atlantic rather than higher ECB interest rates.   



Q: What are your favourite investment ideas for 2018, given the good growth/low inflation environment and still accommodative ECB policy?


Thanks to the efforts made by the ECB and its central banking peers to contain the macroeconomic impact  of recent financial crises and their aftermath, we enter this phase of the cycle with asset prices at elevated levels relative to underlying economic fundamentals. Very low interest settings and central bank asset purchases have driven up asset prices across the board. Despite the favourable economic outlook, investors face modest returns over the medium term as policy rates rise and asset prices normalise. At that horizon, the central issue is whether that adjustment will be smooth or abrupt and disorderly. That said, the strong current momentum in economic activity, benign inflation and the prospect of continued easy policy in the Euro area have created an environment for strong performance in risk assets at shorter horizons.



Q: 2017 was a year of great political risk in Europe. But the defeat of populism in Europes elections (France, Netherlands, Germany, Austria) suggests that this risk is diminishing. Is that the case, bearing in mind that Italy goes to the ballots in spring? What are the challenges to the political stability of Europe. Will the German political crisis and a (possible) weaker German government affect key European issues?


With the considerable benefit of hindsight, the immediate political risks associated with 2017 elections in continental Europe were overstated. The surprises seen in both the UK’s EU referendum and the US presidential election weighed heavily on market expectations. That said, even as the cyclical economic situation improves, at longer horizons market participants need to avoid complacency about political risks. Support for populist parties remains strong; populist policies and sentiment have been expropriated by the political mainstream; and the outcome of elections (where the populist candidates often ran second to a broad – and thus somewhat incoherent – coalition of mainstream parties) has served to legitimise populist parties as the main opposition to the government. If the democratic pendulum were to swing again, the prospect of a populist government being elected cannot be ruled out in the next or subsequent electoral cycles.


Yet in the shorter term, we expect political risks to remain contained. In Italy, our expectation is for a broad coalition of mainstream forces (not dissimilar to the current administration) to govern following the elections. Such a government would not disturb the systemic stability of European markets in the manner seen in 2011, as its defining principle would be to sustain the calm achieved by the ECB’s policy interventions following Mr. Draghi’s famous “whatever it takes” speech in July 2012. But such a broad coalition is unlikely to exhibit the internal cohesion and direction required to implement the reforms that the Italian economy and institutions need. In short, we are likely to see a continuation of the status quo, muddling through rather than decisively resolving underling problems.


Even after its own as yet inconclusive election, Germany remains a key player in Europe. We doubt there is popular support in Germany to move forward quickly with grand plans to deep fiscal integration and governance within the Euro area. Nevertheless, Germany will continue to play its necessary role underwriting the Euro project, albeit in opaque ways – such as toleration of sovereign asset purchases by the ECB – that can fly beneath the radar of sceptical German voters.

Q: Can a transition agreement be reached in Brexit negotiations? Will political tensions and uncertainties in the UK persist?


The recent intermediate agreement between the UK and the EU-27 permits Brexit negotiations to move forward to two issues: transitional arrangements for the period immediately after Britain leaves the EU in March 2019; and the new, long-term economic and political relationship between Britain and the EU.


The mechanics of the former are relatively straightforward. The UK government has accepted that any such transition will take place in the form of maintaining the status quo (and thereby accepting EU rules, regulations and budget demands). Given that, the only outstanding issues are whether the transition is open-ended and, if not, how long it will last. We expect a two-year transition to be agreed. The main obstacle to such an outcome lies not in the negotiations between the British authorities and the EU-27, but rather within UK domestic politics where a hard core of Brexit-supporting members of parliament may attempt to scupper any transitional arrangement to ensure a quicker and more decisive hard break from the EU.


Negotiations over a new long-term trade, economic and political relationship between the UK and the EU are likely to prove more tortuous. In the end, we expect a free trade agreement to be reached. But for the UK this will mark a significant deterioration in access to the EU single market relative to the current situation, in particular as a pure free trade agreement will not extend to services where the bulk of UK exports to continental Europe are concentrated. Moreover, among the EU-27 there are likely to be greater differences over how to govern trade in the future. The united front that the EU-27 has thus far demonstrated to the UK over the transitional arrangements may then fracture, further complicating the outlook.
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