RBC BlueBay: Germany shuts down remaining power plants

April 21, 2023

Mark Dowding, BlueBay CIO, RBC BlueBay Asset Management, looks at the economic outlook for the US, EU, and Japan.

Volatility in financial markets has continued to subside over the past week, with the Vix dropping to levels last seen towards the end of 2021. Stress in the financial sector continues to abate, helped by robust bank earnings, which have helped underline that banks remain well capitalised and in a fundamentally healthy operating state.

The past week has seen limited economic data releases from the US, though expectations of a last Fed hike have continued to firm, on an assessment that the economy retains momentum. However, we see evidence that demand is cooling and tighter credit conditions are likely to crimp bank lending over the next several quarters.

Weaker US personal tax receipts on the back of lower capital gains in the past year also suggest that disposable income growth has slowed and this may start to weigh on consumption. In this context, we look for growth to slow over the months ahead and for the US economy to tip towards recession at the end of the year.

However, with inflation remaining elevated, we remain sceptical that the Fed will plan on cutting interest rates, prior to the fourth quarter of 2023.

Lower US tax receipts also highlight the potential for the US government to run out of cash by the end of June, in the absence of an agreement to raise the debt ceiling. Early skirmishes in Congress have seen Republicans propose a substantial hike in the debt ceiling, in exchange for commitments to cut government spending, which has been roundly rejected by the White House.

Dysfunctional US politics mean that both Democrats and Republicans are likely to take discussions to the wire, in the hope of scoring a political advantage. We think that the prospect of a default on Treasury debts remains incredibly unlikely. However, this won’t stop pressure building and weaker tax receipts have accelerated the timetable, which needs to be delivered in order to broker a compromise.

Consequently, uncertainty around the debt ceiling could be a factor which weighs on risk assets over the coming month or two, even if this should not have a long-term, or lasting, significance.

In the UK, this week’s inflation data represented more bad news for the Bank of England (BoE). Headline CPI remains in double digits and we retain a view, expecting UK inflation to overshoot for longer than is the case in other advanced economies.

We expect growing evidence of inflation divergence between the UK and its peers to emerge over the course of the next several months. This is likely to put pressure on the BoE to keep hiking interest rates, given that activity data has remained relatively healthy in the first quarter, and also following evidence that wage growth has accelerated to around 7%.

However, the BoE continues to need to tread very carefully, for fear of provoking a collapse in UK house prices. There is a sense that the impact of monetary tightening is non-linear and it is a matter of when, not if, UK consumers are forced to retrench, in the wake of rising costs and higher mortgage rates.

A sharp fall in UK house prices could lead to renewed fears of UK financial collapse, and so we feel that the BoE is currently being forced to tighten policy relatively reluctantly. However, more restrictive policy looks like it will be needed.

The psychology around inflation in the UK is very different to what we see in other economies. For example, policymakers in other countries speak about the importance of bringing inflation down and restoring price stability, in order to create the conditions for medium-term economic prosperity.

By contrast, in the UK the narrative seems to be much more about a ‘cost of living crisis’. This narrative seems to feed into a dynamic where workers will need to chase pay gains in order to restore purchasing power, feeding into a de-anchoring of inflation expectations. By shifting and deflecting the blame for inflation on external factors, so this is leading to poor policy making. This may serve to continue to cement UK economic underperformance relative to its peers.

This leads us to look for the pound to weaken over the medium term, though we expect to see more traction on this trade as and when economic activity starts to slow more decisively in the UK.

Elsewhere in Europe, Brussels has been pushing the case for an ever more robust banking union. As expected, the fallout from SVB and CS is likely to be increased regulation, which continues to make banks more conservatively managed. This may limit scope for earnings growth, but in making banks safer, so we see this underpinning credit quality, on the part of debt investors.

Meanwhile, in Berlin we have been focussing on renewed enthusiasm for fiscal austerity in Germany with demands to return to a ‘black zero’ in the context of a balance budget. Accommodative fiscal policy has helped to support EU economic activity in recent months and as stimulus wanes, this is a factor, in addition to monetary tightening, to look for weaker growth in the Continent over the months ahead.

Meanwhile, it will be important to watch for signs of tension within the EU with respect to the application of the bloc’s budget rules. Countries in Southern Europe continue to demonstrate a desire for a more relaxed fiscal approach, in contrast to the Germanic desire to balance the budget.

That said, there is a sense that German leadership is lacking in the EU right now, and that German demands are brushed off much more readily than was the case than when Merkel was in power.

Over the past year, German policymaking around Ukraine has cost it in terms of its authority on matters pertaining to foreign policy. Meanwhile its environmental policies are also in tatters with a supposedly green administration presiding over wanton climate damage and an increase in carbon intensity.

This was demonstrated in data this week showing that France is currently emitting 50g of carbon per kWh, compared to Germany’s emissions running at 605g carbon per kWh. This stark contrast is a function of the energy mix in power generation, with Germany increasing its use of coal to 40%, largely thanks to its decision to phase out nuclear.

Arguably, nuclear has a strong role as a transition fuel and it is notable that even Japan (a country prone to earthquakes and still scarred by the Fukushima disaster) has returned to nuclear, even as Germany this week shut down its remaining power plants.

In Japan, today’s CPI data continue to highlight inflation pressures in the country. Core price growth is now higher than at any time since 1981 and fundamentally speaking, there can be no doubt that the economic conditions in the country are very different today, compared to what was the case when Yield Curve Control (YCC) was incepted in 2016.

From this perspective, there seems widespread consensus that Governor Ueda will soon move to terminate Japan’s policy of YCC as it embarks upon a path of gradual monetary policy normalisation, which may see cash rates hiked early next year.

Notwithstanding this, there is widespread agreement that policy change may occur at the June – rather than next week’s April – meeting. Yet we would emphasise again that the YCC renders effective central bank communication ineffective. There has to be total adherence to maintaining YCC up until the moment when it is scrapped, in the same way that one can’t pre-announce a move away from a policy of fixed exchange rates.

This noted, policy changes will need to come as a surprise and we see no reason why such a surprise could not be delivered as early as next week, if Ueda has come to the conclusion that it will need to end at some point relatively soon. In this context, there is little merit to a delay and actually an advantage to moving early, if in doing so the BoJ can adjust policy, before a build up of speculative pressure takes place.

Credit markets have enjoyed a robust month, as spreads recover from the weakness experienced during March. Lower volatility has also created a benign backdrop, but we are wary of how long this period of calm may last. In EM, local rates have been outperforming in the past few weeks.

In credit, frontier spreads have been under pressure, with growing default concerns in North and Sub-Saharan Africa. FX has witnessed a modest recovery for the dollar and some reports suggest that speculative investors are now positioned long in the greenback.

However, we remain inclined to look for a softer dollar at this juncture and we see incoming newsflow in the month ahead more likely to favour the euro and yen relative to the US unit.

Looking ahead

There is relatively little on the data calendar over the week ahead and so it is possible that calm conditions will continue. However, the week which follows could see a return to more elevated volatility in the wake of the Fed meeting as well as US payrolls data.

A re-intensification of the conflict in the Ukraine is also likely soon, with a much-awaited spring Ukraine offensive in the offing. It looks like we should enjoy the calm while it lasts, but be prepared to reduce risk in anticipation that this won’t be able to carry on for too long….