On the cusp of a second wave

Encouragingly, the rise in cases has not so far been accompanied by a rise in deaths, but that is no excuse for complacency. Governments are acting quickly to impose localised measures to manage the virus’ spread.

It was inevitable infection rates would rise given much greater mobility over the summer holidays, the re-opening of schools and the return of workers to offices.

Renewed restrictions, even if localised, can be severe and carry negative growth implications.

In the UK, the government announced further measures on Tuesday which may last for six months. Pubs and restaurants must shut at 10pm. Guidance on wearing masks was tightened and attendance at conferences and sporting events will not re-open on 1 October. Nationwide, social gatherings are limited to six. The UK’s chief medical officer and scientist have warned that if left unchecked, daily infections could hit 50,000 by mid-October and deaths could climb significantly. Prime Minister Johnson has warned that stricter measures will be forthcoming if required.

The surge of cases shows that, in the absence of a vaccine, lockdowns are only a short-term solution. ANZ Research expects strict limitations and stronger enforcement of social distancing requirements will become common place in the EU and UK along with renewed recommendations to work from home, shielding the elderly and vulnerable from exposure to the virus and curbs on non-essential travel.

Particularly vulnerable

For the European economy, as with elsewhere, the momentum and sustainability of the recovery depends on the path of the pandemic. The sharp sell-off in stock markets since the end of last week signals investors have underlying concerns. While dovish, the Federal Reserve and European Central Bank (ECB) added no new stimulus and, against the backdrop of rising growth anxiety, equity investors seem unimpressed by forward guidance.

Already, Q3 has shown the shape of the recovery is mixed depending on the sector. In the euro area, manufacturing is enjoying a V-shaped rebound, but services much less so.

Transport is severely disrupted by travel restrictions. Tourism, retail and hospitality are limited in their recovery by existing and expected restrictions, and uncertainty is curtailing hiring and investment.

Of EU employment, 70 per cent is in service sector jobs, and that figure is even higher in the UK. The balance of risks to growth and deflation are skewed to the downside.

For the ECB and the Bank of England (BoE), this economic and health framework poses a challenging environment. Of the two, ANZ Research’s analysis indicates the BoE has greater policy optionality. It has scope to:

• introduce negative interest rates,
• increase quantitative easing (QE), and
• work closely with the UK Treasury to facilitate enhanced credit and fiscal measures.

ANZ Research forecasts the BoE will cut interest rates to zero soon, before taking them negative next year. It is also expected the BoE will increase the size of its QE stock by at least GBP100 billion as early as Q4 this year.

The extent and timing of further BoE policy measures will depend on the outcome of the trade talks with the EU, response in the labour market to the ending of the furlough scheme on 31 October and the degree of fiscal stimulus in the forthcoming budget (expected in late Q4).

ANZ Research’s estimates of an augmented Taylor Rule for the UK, which attempts to estimate the shadow policy rate given deviations from the central inflation target (2.0 per cent) and full employment (4.0 per cent), argues the policy rate should be negative. For example, if UK unemployment were to rise to 6.0 per cent and inflation stay at current levels, the appropriate bank rate could be as low as −0.75 per cent.

Limited scope for lockdown

For the ECB, the policy backdrop is considerably more complicated. European heads of state agreed to a EUR750 billion Recovery Fund over July’s drawn out and acrimonious EU Summit. There is no appetite among fiscal hawks to increase common European fiscal spending any more. In fact, the medium term focus of fiscal policy is turning towards sustainability and an urgent need for economic reform.

Governments needing to access recovery funds must submit detailed plans on how the money will be spent, what reforms will be implemented and how the public finances will be returned to a medium term sustainable path.

The appetite of the ECB governing council for additional QE is also questionable. While the Pandemic Emergency Purchase Programme (PEPP) will run until the middle of next year and weekly asset purchases can be stepped up, the appetite for additional QE is beyond that is unclear. ANZ Research expects recent speculation that the public sector purchases (PSPP) could be made flexible and therefore not in line with the EA capital key could meet staunch resistance.

The challenges facing the European banking sector are significant in terms of cost structures, profitability and growth opportunities. It is too early to tell what the rise in corporate indebtedness will mean for bad debts once moratoriums on repayments and mortgages lift. There has been a reluctance to cut the deposit rate below –50 basis points and compress net interest margin (NIM) further. The preferred interest rate to adjust is now the marginal rate on targeted longer-term refinancing operations (TLTRO III (–100 basis points)).

Upside likely constrained

As the EU and the UK are on the verge of a second wave of the pandemic, fragile growth confidence is deteriorating. The monetary and fiscal space to deal with more national lockdowns is limited so we expect governments to respond quickly with more broad based and strictly implemented limitations on social interactions.

As the market simultaneously downgrades the near-term growth path in the absence of a vaccine, risk appetite for EA and UK equities has fallen. This could constrain the upside for the euro in the near term. Sterling remains challenged by a deteriorating growth backdrop, looming negative interest rates and trade uncertainty.

Brian Martin is Senior International Economist at ANZ