The last ECB meeting of the year will take place this Thursday. Amid an atmosphere of inflation and Omicron, the industry is waiting to see the new macroeconomic projections for the coming years, and the effects of the Pandemic Emergency Purchasing Programme (PEPP) in the markets. Christine Lagarde, President of the European Central Bank, has exposed her views on the inflation stating that at the moment inflation has the shape of a hump, and so as a hump, it will eventually decline.
Prior to the meeting, we have received the views and insights of the professionals within the asset management industry. We have received commentaries from Pimco, Axa IM, Generali investments, Ostrum, Allianz Global Investors, T. Rowe Price and MFS Investment Management.
Konstantin Veit, Portfolio Manager at PIMCO
At the December meeting, the Governing Council will publish new macroeconomic projections, including its inaugural assessment for 2024. It will also communicate the Pandemic Emergency Purchase Programme (PEPP) purchase pace over Q1 next year, as well as disseminate the game plan for quantitative easing after the PEPP ends in March 2022.
The ECB currently buys around €70bn per month under the PEPP, plus €20bn per month under the regular Asset Purchase Programme (APP), a pace we believe will broadly continue over Q1 next year.
While we do not have a strong view on the mix of asset purchase acronyms beyond March 2022, we continue to think the Governing Council will avoid a cliff-effect on asset purchases and choose instead to gradually reduce the pace from the current €90bn per month to a steady-state rate between €40-60bn per month over Q2 next year. This could potentially be in the form of a nine month €200-300bn post-PEPP transition envelope.
We also think the ECB will maintain the current framework of revisiting the pace of asset purchases on a regular basis, with a view to gradually relegating them from a duration extraction tool to a pure policy rate signaling device over time.
Investment implications:
- ECB support remains an anchor for risk assets but valuations offer limited room for spread compression.
- Risks to the macroeconomic outlook remain elevated and the implementation of the new ECB monetary policy strategy subject to uncertainty.
Gilles Moëc, Chief Economist at AXA Investment Managers
We are not expecting the same level of clarity from the ECB next Thursday. Let’s start with what probably is consensual within the Governing Council: not hiking the policy rate in 2022. The debate between hawks and doves has become very public, but still focuses squarely of quantitative easing. If hiking rates is not on the table, then it’s probably acceptable to a majority of the Council to continue quantitative easing until the end of 2022 – finishing earlier than that would make it difficult for the market not to start pricing hikes next year, as they did for a short time in late October-early November. What is also probably consensual is that the continuation of QE will need to be done via the old APP scheme while PEPP would be seen as “overkill”.
Everything else is being fiercely discussed in our view. The doves would probably argue in favour of recalibrating APP significantly up to cushion the impact of PEPP termination on sovereign spreads for the entirety of 2022. Hawks probably want to “wean the market off” QE faster and want to retain the possibility of stopping QE altogether if inflation were to prove persistent beyond the middle of the year. A compromise needs to emerge. We thus elaborate on the 2-stage approach scenario we sketched out last week. We think the central bank will announce an intention to purchase EUR40bn per month through APP from March to December 2022 at least, but with a “rendez-vous clause” to recalibrate the quantum at each new forecast batch, so in practice in June and September. This suggests the ECB will be subject to regular speculations throughout next year, which would be conducive to quite a bit of volatility.
The quantum and timeline of APP won’t be the only point of focus on Thursday. PEPP is much more flexible than APP. This materialized for instance in the fact that Greek sovereign bonds are eligible to the former but not to the latter, since they still lack the “investment grade status” from the rating agencies which the ECB looks at. There was some expectation that Moody’s and S&P would have upgraded the sovereign in October and November 2021, but they “passed”, despite the undeniable improvement in the country’s economic performance and macro-management. It may well be that the agencies would prefer to wait until the next general elections – which must be organized by 6 August 2023 – before making that move. Mitsotakis’ centre-right New Democracy remains dominant in the polls but has lost some ground in the last months. There is certainly a case to provision for some insurance policy for Greece in 2022. A solution would be to use the reinvestments from PEPP to be heavily skewed, if need be, towards this constituency.
A similar approach could be adopted to deal with potential fragmentation risks elsewhere in the periphery. Italian government bonds have benefited a lot from the PEPP’s deviation from the capital key. A stricter return to the key would be expected with QE reduced to APP, leaving the Italian market vulnerable. Diverting PEPP reinvestment towards this market would also be a way to provide some protection. A key focus for us on Thursday will be the extent to which the ECB will elaborate on these various streams. We think the market may react negatively if the ECB is not explicit enough on the possibility to PEPP’s reinvestments tactically. Note finally that while we expect the ECB to keep the TLTROs on its arsenal on a permanent basis – in all likelihood without the special “50 basis points subsidy” – we may not hear about the calibration of any post-June 2022 instalments this week already.
Of course, we will also pay quite a lot of attention on the ECB’s new forecasts. Most observers – and ourselves – expect the inflation forecast to be slightly below 2.0% in 2024. This could raise some questions. Indeed, if the ECB acknowledges that it doesn’t expect inflation to be back to target by the end of its forecasting horizon, one may wonder why then they don’t do more on their stimulus.
Martin Wolburg, Senior Economist, Generali Investments
- Omicron is unsettling markets – and uncertainty will remain high until the variant’s impact on Covid hospitalisations and deaths becomes clearer.
- May central banks delay the policy normalisation? Don’t expect too much help: amid a deteriorating growth-inflation mix and persistent global supply bottlenecks, policy makers are running short of silver bullets.
- We favour a very prudent tactical stance amid high near-term uncertainty. But with the earnings consensus looking reasonable and valuations supported by rock-bottom real yields, the recent correction may ultimately render opportunities for reloading risk assets as Omicron fears recede.
Will the pandemic ever end? Vaccines have done a great job reducing the risk of severe cases, but the new infection wave suggests they are not circuit-breakers – as the WHO itself starts to admit. Worries about the new variant Omicron have more than wiped out earlier November equity gains, with 26 Nov. seeing the deepest daily drop in over a year. The new variant seems highly infectious owing to numerous spike mutations and may quickly turn dominant globally, adding to worries over fast accelerating new Covid cases in Europe.
Yet thus far, little is known about the prospective health damage. The key question is whether Omicron will severely undermine vaccines’ effectiveness in preventing hospitalizations and deaths. Early evidence does not point to severe diseases, but scarce data and usual lags suggest firm conclusions are premature. Producers have expressed confidence they could adjust mRNA jabs within 100 days. But this lag and the subsequent roll-out would still leave plenty of scope for the virus to disrupt supply chains and force renewed lockdowns.
Policy makers may help and cushion the market impact in case renewed lockdowns become necessary. Central banks may slow or even pause the removal of strong monetary accommodation. Yet aggravating supply disruption (left chart) and a prolongation of crowded global demand for goods will increase the inflation headache, preventing a particularly strong kind of support.
Recent market setback also bears opportunities
In the near term we thus favour a very prudent approach to tactical risk taking. Still, unless the variant’s health impact turns out to be a game changer in vaccines’ efficacy, the recent market correction may provide opportunities in cautiously overweighting risk assets in the portfolios.
For one, economic data surprises have bottomed into autumn. Also, with consumers sitting on large savings, firms still enjoy high pricing power, allowing them to pass higher input prices. This protects margins (right chart) and underpins the earnings outlook. Central banks will proceed carefully, helping ultra-low real yields to underpin valuations. Governments and firms have also learnt to better cope with measures aiming at a lower circulation of the virus. Investors will also hope that vaccine innovation will help the health sector to tackle even disruptive Covid mutations. New drugs are also coming to the market, and although efficacy and volumes are disputed, should also contain the social and economic impact.
IG Credit in Europe looks favourable following the recent widening, not least because non-financials remain a key policy tool for the ECB. While we expect higher yields into 2022, we caution against any strong duration bias, with the risks of safe haven bids and growth concerns sill sizeable. The USD looks dear after a near 7% advance (DXY) since early June, but policy divergence and global Covid worries may still underpin the greenback short term.
Axel Botte, Global strategist at Ostrum AM
The ECB will make a decision on the end of PEPP on Thursday, whilst keeping all options open to be able to increase the APP on either a temporary or more lasting basis. The TLTRO decision is less urgent, but the outstanding amount of refinancing operations (€ 2.2 trillion) can never be refinanced on the markets, in particular for the most fragile southern European banks.
Franck Dixmier, Global CIO Fixed Income at Allianz Global Investors
We expect confirmation of the end of the Pandemic Emergency Purchase Programme (PEPP), with tapering by the end of March 2022 and an upward calibration of monthly purchases under the asset purchase programme (APP).
Unlike in the US, we expect no news from the ECB on rates – particularly while the ECB continues to analyse the transitional inflation peak.
Investors, whose expectations are well anchored, should remain calm, but spread volatility will likely increase.
The ECB continues to analyse inflation as transitory, in line with the consensus among economists. In the euro zone, core inflation reached 4.9% in November, but core CPI is at 2.6%, well below the US, and no price/wage spiral is observed. The ECB therefore expects inflation to be below its 2% target by the end of 2022.
The ECB should give details on a new stage of its monetary policy, which it had characterised as “forceful and persistent“. We therefore expect the central bank to communicate the need to maintain its voluntary monetary policy to continue supporting the economy and achieve its medium-term inflation target of 2%.
We are therefore expecting the confirmation of the end of the PEPP, implemented in March 2020, with tapering until March 2022.
We expect more volatility in periphery spreads and credit, but no major divergence as the ECB, although less present in the markets, should remain vigilant and ready to intervene.
Tomasz Wieladek, International Economist at T. Rowe Price
The ECB will meet this week to decide on the fate of the PEPP programme, and how a modified APP programme might replace the PEPP. In an ideal world, the ECB would delay some of these decisions because of the unusual degree of uncertainty at the moment. While data from South Africa suggests that hospitalization from the new Omicron variant is milder than from the Delta variant, there is a lot of uncertainty about the effects in the Euro Area, where the median age is much higher than in South Africa. On the other hand, some ECB policy makers are concerned about inflation, given that data have continued to surprise forecasts to the upside in the past couple of months.
Ideally, the ECB would wait until February or March to make a decision on the future of the APP in my view, since the Omicron uncertainty may well be resolved by then and base effects should give the Governing Council confidence that inflation is actually falling. However, it seems that the ECB is determined to make a decision on the future of the APP this Thursday.
Any such decision needs to take into account the large degree of uncertainty at the moment. In the past the ECB used to make longer-term commitments on its asset purchase programme. However, this is unlikely now given the large degree of uncertainty. Instead, it is likely that the ECB will raise the monthly purchase pace from the current 20bn pcm to 40-45bn pcm after March 2022, and then review this every quarter. This review will allow the ECB to raise the APP purchase pace if the economy deteriorates, but also reduce it if high inflation turns out more persistent than expected. I believe that the ECB will likely reduce the pace (taper) of APP purchases in Q4 2022, as a result of a strong economic recovery in the Euro Area. Normally, the move to a state-dependent QE policy, from one where QE promises are made over longer stretches of time, would be quite hawkish, since the purchase pace could be reduced as soon as next quarter. This needs to be priced into rates and FX markets. However, there have been a number of leaks about these ideas in the past two weeks, so I believe that the policy option of state-dependent QE is probably already partially priced in.
Annalisa Piazza, Fixed-Income Research Analyst, MFS Investment Management
In light of the looming risks around the fourth wave of Covid caused by the Omicron variant, increasing restrictions across the major EMU economies to reduce a collapse of their health systems and the sharp increase in inflation up to nearly 5% in November; the majority of the Governing Council members are likely to opt for a ‘wait and see’ approach before announcing any firm plans on what is next in terms of QE.
Pandemic Emergency Purchase Programme (PEPP)
As for the future of PEPP, we see no reason for the ECB to change the current ‘moderately lower’ pace compared to Q2 and Q3. Indeed, the fundamental picture has moved in line with expectations and financing conditions have stabilized. In addition, we expect the ECB to announce PEPP will end in March next year, as flagged several times by its officials over the past few weeks. Given additional risks around the pandemic, we expect the ECB to leave the door open to use some flexibility if needed as predicting the impact of the current wave and the new variant now is more art than science.
Asset Purchase Programme (APP)
When it comes to the ‘regular’ QE programme, our baseline scenario is for the APP to be expanded in some shape or form after the end of PEPP but the communication of details might come only in early 2022. Indeed, by then the ECB will have more clarity on the impact of the new wave of the pandemic on the EMU economy and see the first signs of moderating inflation. There is certainly internal division within the Governing Council and those who are more worried about the future of inflation would like to leave the door open for some earlier removal of the exceptional policy accommodation. The decision on the future of the APP programme will be based on medium-term risks around inflation and certainly not on the current supply and energy driven spike in prices. The December ECB projections for growth and inflation will offer a good backdrop to assess whether the inflation target will be reached under the assumption of a cliff-edge in the QE programme.
Inflation projections
We suspect the 2024 inflation projections will be below 2%. Hence, monetary policy needs to remain accommodative. Not only the pre-conditions for an early rate hike are not going to be met anytime soon but also the ECB will be willing to reduce risks of premature tightening of financing conditions and fragmentation that would undermine the transmission of past policy accommodation. It is highly like 2022 inflation expectation of 1.7% will be increased to somewhere a little above target.
Market implications
Should the ECB decide the borrow some extra time and delay further decisions to February next year, EMU yields (and the periphery in particular) might show some volatility near term, also considering the year-end low liquidity conditions. More in the medium term, we expect the ECB to continue to support – at the margin – the periphery as the economies still need fiscal support in the recovery phase (it is worth noting that the output gap in the Eurozone is still negative). In addition, the ECB is not willing to let fragmentation risks to hinder the transmission of past monetary policy accommodation.
All in all, we would expect the ECB future policy to remain relatively supportive in the medium term as QE will be re-shaped to avoid the cliff after the end of PEPP and a rate hike is clearly not on the cards. That said, some short-term modest widening in spreads cannot be ruled out near term as communication risks are high at the current time of high uncertainties that deepen the internal division within the Governing Council.