Lagarde: The challenges ahead

Intermediate

What is the European Central Bank facing?

Becoming the European Central Bank head might sound like the highest-level of any career achievement. The job requires responsibility for setting the Eurozone interest rate policy, controlling the Euros supply and overseeing the biggest European banks, all of that keeping an eye on inflation and unemployment (11 million jobs created over the past decade).

Mario Draghi’s 8 years mandate has been one of the longest and most tormented since the ECB creation. The former Italian central banker became notorious for rescuing the Euro during the 2011 Government Debt crisis which led Greece, Italy and Spain almost to the edge of collapse.

The current Eurozone unemployment rate is at the lowest ever and the continent is still enjoying what seems to be the longest-lasting cycle, with the major economies running at full regime. However, the price European countries and big enterprises are currently paying is non-sense “negative” interest for borrowing money. Under this circumstances ECB already-fat-balance sheet has reached a sound €2.6tn value in asset (corporate and government bonds).

Nowadays, the most creditworthy entities (corporates and governments) are receive interest to borrow money whenever needed, whilst lenders are willing to pay (sacrifice some of their initial capital) to “invest” (shift their money) into what is now perceived as a “safe” asset. I remember the first lecture of my financial asset pricing course at the business school and my professor saying: “There is not such a thing as a free lunch in the financial market unless an arbitrage opportunity might rise”. Paying interest to bear (even little, but existent) counterparty and market risk would not be part of a normal “rational investor” strategy and seems a lot like a “free lunch” That said, some of these companies do not even have to be necessarily profitable, but they only need to be very good at selling the unlimited investment upside dream to eager and income-greedy investors.

On a similar note, European banks are struggling with their business model as their net interest income (by definition their core business-related source of income) has tightened over the last 10 years, ultimately restricting their credit lending minimum requirements and concentrating their credit portfolio (asset) within a small privileged circle of huge sector-leading corporates which, on the other hand, irresponsibly spend all the cheap excess-cash on takeovers (Facilitating industry consolidation and raising industry entry barriers) and bolstering shareholders’ performance (Increased Dividends, Shares Buybacks Programmes). Very rarely companies invest their extra cash in new physical projects, due to the high opportunity cost of continuing to pump up their own equity value. Operations, business investment (one of the main GDP components) and, hence, manufacturing sector have all been negatively affected by decreased competition, excessive liquidity, insurmountable entry barriers, dying core banking and concentrated lending. With a similar reasoning, the various real estate markets across Europe and the other Developed Countries have all peaked to the unsustainable “bubble” size, locking the white-collar class in a social trap made of unaffordable renting, high inflation and low wage growth.     

That said, Mario Draghi left the ECB amid the first signs of economic weakness as aftermath of the negative interest rate and excessive liquidity “paradox” previously described. Interestingly, the once strongest and most solid Eurozone leader – Germany – seems to be the ultimate trigger of the approaching recession. The Eurozone manufacturing engine is struggling amid autos sector slowdown and trade tensions both weakening the manufacturing goods demand.

The challenges for Lagarde

The successor, Christine Lagarde, fortified by years spent as head of the International Monetary Fund, has handed over a situation that is everything but reassuring. The former French minister will likely have to fight a one-in-a-lifetime recession with no bullet-proof vest. The new ECB chair mandate will be a milestone in Europe’s history. Imagine a European Union without the United Kingdom (Brexit) and a Eurozone whose leader in recession (Germany) with no capacity to pick up the politically unstable Spain, Italy, Greece and Portugal. We might experience a strong geopolitical and economic paradigm where the Eurozone and the European Union cease to exist, as global growth slowdown (the IMF itself cut the global growth outlook to the lowest since the Great Financial Crisis) along with the lack of central banks’ firepower (to stimulate their respective economies) rise loud criticism on the ECB actions’ effectiveness.

Leaving for a minute what might sound a “conspiracy theory”, global investors crave for any hint Ms Lagarde might release on the future of Euro, Interest Rate policy and, in general, her main priorities. For now, she seems to focus on climate change, public spending and inflation control. The new ECB head was defined by many as an “unconventional” choice mainly due to the lack of direct expertise (she is not an economist) on devising monetary policies. That is why, she will likely rely on the former Irish central banker Philip Lane, nominated ECB Chief Economist. Ms Lagarde was admired for her diplomatic skills and ability to find consensus while leading the IMF, such as during the 2012 Greek bailout talks that prevented the Eurozone to break up. She is seen as somehow a continuation of what Draghi started. Where she might differ is on the asset purchases objective to address climate change (green bonds?), to encourage governments to invest more in C02 emissions reduction. There is no doubt the fiercest challenge will come from Berlin, where the Bundesbank chair Weidmann already appealed to court providing evidence that the ECB has benefitted the southern European countries and penalised the German prudent savers. Many investors expect Germany to issue a new major fiscal stimulus, pushed by Ms Lagarde.

Editor

Stefano has developed a multi-asset investment experience throughout his professional background. He worked for QW Capital LLP, the London Stock Exchange Group and Goldman Sachs before joining Kyli... Continued

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