Macro Wrap-Up

A Black Zero Sum Game

Topics - Macroeconomics

${ numberSection } ${ text }
A Black Zero Sum Game

If you could get paid 70bps a year to borrow money for ten years, would you do it? The German government has said "nein." They think that borrowing, even at negative rates, should be avoided at all costs. 1 1 Close Or perhaps more accurately “at all gains” since they are currently paid interest to borrow. The proposed 2020 German budget reflects this schwarze Null or “black zero” deficit policy. 2 2 Close Germany is not embracing Modern Monetary Theory. While other countries may pad their budgets with optimistic forecasts, Germany has tended to underestimate its future tax revenues. 3 3 Close Midoes, Catarina and Wolff, Guntram. “Germany’s even larger than expected fiscal surpluses: Is there a link with the constitutional debt brake?” Bruegel, 13 May, 2019. When a German budget says zero deficits, it means zero deficits. This famed German fiscal responsibility has angered some of its neighbors and puzzled economists who view fiscal stimulus as a natural step when monetary policy is stretched. The debate is important for investors. A material move away from the black zero policy could have an immediate and significant effect on asset prices. 

Many commentators take a simplistic view as to why Germany is so deficit averse. They look back to the hyperinflation of the 1920s and assume that German policymakers fear that any deficit spending will lead to that outcome. The reality is more complex. Germany has not always been as tight with its budget. After reunification in 1990, Germany ran government deficits for the better part of the next twenty years, and by 2010 Germany’s debt swelled to over 80% of GDP. That led to a 2009 law mandating a balanced budget, which was as much a reaction to the economic challenges of reunification than any longer-term history. 4 4 Close Technically the law mandated the structural deficit be close to zero and had a few exceptions. Nonetheless, Germany has been very successful in bringing its government debt down as a percentage of GDP.   

Germany Government Debt/GDP (%)

Source: Bloomberg, Deutsche Bundesbank. Data from 12/31/91 to 12/31/18. 

Germany 10 Year Yield (%)

Source Bloomberg. Data from 12/31/91 to 8/14/19. 

The law has served its purpose. Since 2010, German debt/GDP has shrunk almost every year. At the same time, the German labor market has been booming. Unemployment has fallen to post-war lows. It has the second-largest positive trade balance in the world and is one of the highest as a percentage of GDP. It sells much more to the rest of the world than it buys. The German economy is known for its strength in manufactured goods, but it takes more than just an enormous export machine to have such a large trade surplus. Germany also has a very high savings rate, and consumption is a smaller part of GDP than it is in some other developed countries. This mix of savings, fiscal discipline and exports is part of what has become known as the “German model.” 5 5 Close The German model also refers to the unique relationship between German industry, government and labor used to promote innovation and economic growth. It does not refer to Claudia Schiffer.

Many folks in Germany think the German model has been successful and with good reason: the country is very prosperous. German officials have preached its virtues to other European countries but have received a mixed reception. 6 6 Close It is not particularly popular in Italy and Greece. Germany is not without its own economic challenges. Recently, German growth has stalled, business investment has fallen, and auto exports are down. There is a feeling among some local economists and politicians that the cyclical weakness in Germany has been caused by external forces such as slowing growth in China. While it is likely correct that the current slowdown is not related to domestic consumption, it illustrates one of the weaknesses of the German model: any economy that relies so much on exports and external surpluses will be vulnerable to events beyond its borders. The last time Germany was in recession was during the European debt crisis, also an external shock. 

It’s not surprising that the German model would also lead to low yields. Large pools of domestic savings provide demand for the local debt. This adds to the perception that Germany is a safe place to invest, which increases international demand for German debt. The fall in government debt levels reduces the supply of safe assets. While the European Central Bank has played a part by bringing rates down, the conditions were already there. 

For outside observers it would seem these low rates give Germany the luxury to borrow and stimulate the economy, but it’s not clear where Germany would want to spend its money. The U.S. President has told Germany that it should invest more in its military. Social programs are always an option, and while Germany has an extensive safety net, it spends less per capita than some of the other European countries. Some folks in the U.S. think that Germans like to buy nuclear power plants in Springfield, but in fact Germany is in the process of decommissioning all of its reactors. 7 7 Close Maybe the losses taken in selling the plant back to Mr. Burns soured Germany to nuclear power. Last week, reports indicated that Germany would increase spending on reducing emissions and combatting global warming. 8 8 Close Reuters: “Exclusive: Germany eyes fiscal U-turn with new debt to finance climate plan,” 8/8/19.   The recent electoral successes of the Green Party made this believable. Perhaps we will see some ESG economics in action. 

The German government has disputed the reports. Finance Minister Olaf Scholz, the highest-ranking member of the SPD in the governing coalition, has denied that any environmental or other spending would be financed through additional borrowing. 9 9 Close Reuters: “Exclusive: Germany eyes fiscal U-turn with new debt to finance climate plan,” 8/8/19. The fiscal discipline consensus, however, does seem to be weakening. Some business groups have come out against the balanced budget law. Even a senior member of the ruling coalition has talked about the need for more investment in transport, infrastructure, or other things. 10 10 Close Reuters: “Merkel protégé says priority is to invest as economy stutters,” 8/15/19.   The traditional parties have lost support, and the current government looks precarious. It is possible that some of the rising parties, such as the Greens, might look to end black zero even if they’re reluctant to make that the centerpiece of their platforms.  

While a real fiscal push does not seem imminent, it is worth considering what would happen if it ever does occur. It could completely upend the current economic order in Europe. It could break the cycle of negative rates there by adding both economic demand and debt supply. It could also reverse the downtrend in the euro and ease the difference in yields between Bunds and other developed markets. It would be a big change for Germany, but it would probably be a bigger change for markets. 

What We Are Watching

FOMC Minutes (Wednesday)
The Fed cut rates by 0.25% at its July meeting, but the post-meeting statement and press conference sounded noncommittal with respect to further easing. The Minutes of the July 31st FOMC meeting will be released next week, and markets will likely focus on participants’ discussions about the anticipated magnitude of the easing cycle and their perception of the severity of the economic slowdown. Given the hawkish tone of the July statement (and two dissents from committee members opposed to the cut), the discussion could come across as hawkish relative to current market pricing, which implies significant further easing over the next year. If so, the minutes may have a negative effect on equity markets and lead to further flattening of the yield curve. On the other hand, the fact that the meeting took place before the recent escalation in trade tensions in August may cause market participants to view the minutes as dated, diluting some of the market impact.

Eurozone PMIs (Thursday)
Eurozone growth has slowed significantly over the last few quarters, weighed down in large part by weakness in manufacturing. Business surveys have pointed to continued deterioration in industrial activity in recent months, with the Eurozone Manufacturing PMI and German IFO both hitting multi-year lows in July. In contrast, the service sector has been comparatively stable, with continued modest growth. If either of the PMIs published this week shows further declines in activity, it would add to fears that the eurozone economy could be sliding towards recession. This might further undermine sentiment in regional equity markets. 

Fed Jackson Hole Conference Begins (Friday)
The Federal Reserve Bank of Kansas City hosts its annual Economic Policy Symposium in Jackson Hole, Wyoming this week. This event includes the gathering of high-level officials from central banks, academia, governments, media and financial markets. The topic of this year’s gathering is “Challenges for Monetary Policy.” While the subject matter is certainly topical and is likely to include robust discussion, markets will be listening closely to key central bank members who speak at the event. In past years, the event has served as an opportunity for central bank members to communicate shifts in monetary policy. Given risks to trade and global growth have increased since the Federal Reserve and European Central Bank last met in July, the event could include notable and market-moving comments. With both the Fed and ECB expected to ease at their respective meetings in September, any comments around the potential size and path of easing will be watched for closely. Current dovish market pricing has set the bar high for speakers and any form of less dovish than expected rhetoric could lead to a continuation of the recent sell off in risky assets.

This material has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and AQR Capital Management, LLC (“AQR”) to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. The information set forth herein has been provided to you as secondary information and should not be the primary source for any investment or allocation decision.

 

Past performance is not a guarantee of future performance.

 

This document is not research and should not be treated as research. This document does not represent valuation judgments with respect to any financial instrument, issuer, security or sector that may be described or referenced herein and does not represent a formal or official view of AQR.

 

The views expressed reflect the current views as of the date hereof and neither the author nor AQR undertakes to advise you of any changes in the views expressed herein. It should not be assumed that the author or AQR will make investment recommendations in the future that are consistent with the views expressed herein, or use any or all of the techniques or methods of analysis described herein in managing client accounts. The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Charts and graphs provided herein are for illustrative purposes only.

 

The information in this document may contain projections or other forward-looking statements regarding future events, targets, forecasts or expectations regarding the strategies described herein, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved, and may be significantly different from that shown here. The information in this document, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons.