Ahead of the Curve: Europe is the new China
The dust is settling on the crisis, and markets are now focusing on the future. However, we would argue that the scenarios of ‘secular stagnation’ and ‘normalisation’ are incomplete frameworks for understanding the post-crisis world. Instead, ‘euroglut’ – the global imbalance created by Europe’s massive current-account surplus – will be the defining variable for the rest of this decade.
Euroglut implies three things: a significantly weaker euro (we forecast 0.95 in EUR/USD by end-2017); low long-end yields and exceptionally flat global yield curves; and ongoing inflows into ‘good’ emerging market assets. In other words, we expect Europe’s huge excess savings combined with aggressive ECB easing to lead to some of the largest capital outflows in the history of financial markets.
What is euroglut? It is a global-imbalances problem. It refers to the lack of European domestic demand caused by the euro-zone crisis. The clearest evidence of euroglut is Europe’s high unemployment rate combined with a record current account surplus. Both are a reflection of the same problem – an excess of savings over investment opportunities.
Euroglut is special for one reason only: it is very, very big. At around $400bn (€310bn) each year, Europe’s current account surplus is bigger than China’s was during the 2000s. If sustained, it would be the largest surplus ever generated in the history of global financial markets. This matters.
A domestic implication of euroglut is that FX weakening will not be an effective policy response. Does the euro-area need an even bigger trade surplus? Europe faces a problem of domestic, not external demand. In any case, the global environment is hardly conducive to export-led growth: Japan has engineered an appreciation of close to 50% in USD/JPY, yet exports have failed to recover.
This lack of FX responsiveness does not mean the ECB does not care. In the absence of fiscal policy or other ‘animal spirits’-boosting initiatives, there is little left for the central bank than to push yields and the currency lower. QE in Europe will be ineffective, but it will happen anyway – it is the only tool the ECB has to protect its mandate.
Outside Europe, euroglut means that, as the world’s biggest savers, Europeans will drive international capital flow trends for the rest of this decade. Europe will become the 21st century’s largest capital exporter. This statement is close to an accounting identity – a surplus on the current account implies capital outflows elsewhere. Our premise is that the next few years will mark the beginning of very large European purchases of foreign assets. The ECB plays a fundamental role here; by pushing down real yields and creating a domestic ‘asset shortage’, it incentivises European reach-for-yield abroad. ECB policy is driving yields down across the board – there will be nothing with yield left to buy.
The asset implications are huge, especially in FX rates, yield curves and emerging markets. As equity, fixed-income and FDI outflows pick up, the euro should face broad-based weakening pressure.
What will Europeans buy? With the spread of US Treasuries over Bunds at record highs, fixed income should be a primary beneficiary of European demand. ‘Secular stagnation’ implies a low terminal Fed rate, resulting in low long-end yields. Euroglut suggests that the level of neutral Fed funds does not matter: the US 10-year yield could easily trade below terminal Fed funds. It happened during the 2000s’ ‘bond conundrum’ and is even more likely now because global imbalances are bigger.
The financial crisis has seen a rotation of current account surpluses away from emerging markets to Europe. At face value, emerging markets are more vulnerable. But the sum of countries’ current account surpluses is larger now than before 2008, so there is more spare capital around. European current account recycling should mean that the marginal demand for emerging market assets is likely to go up, not down.
Just like China’s surplus drove most Asia policy in the 2000s, euroglut will drive policy across Europe. Two economies are already imposing currency floors (Switzerland and the Czech Republic) and one more has imposed negative rates (Denmark). Scandinavia, Switzerland, Poland, the Czech Republic and Hungary are likely to face continued pressure to ease more. All these countries are running current account surpluses, meaning the potential for European capital outflows is even larger. We could see an amplification of euroglut: most of the European continent could end up with negative rates or FX-managed regimes.
The problem with ‘secular stagnation’ and ‘normalisation’ is that they rely on views around growth trends but ignore global imbalances. It is these that remain the most important feature of the global financial system. Europe is the new China, and via large demand for foreign assets, it will play a dominant role in driving global asset price trends for the rest of this decade.
George Saravelos is head of European foreign exchange and rates strategy at Deutsche Bank