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Who is more important – Draghi or Merkel?

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From an economic perspective, the eurozone has had a good year. GDP rose 0.6% quarter on quarter in September, to give an increase of 2.6% for the three months to September compared with the same period last year. Meanwhile, inflation was running at 1.5% in November, with core inflation still extremely benign at 0.9%. To put this into perspective, Q3 growth in the US, the driver of western growth, was 3.3%; and in the UK, where consumers face the unpalatable combination of declining real wages and Brexit uncertainty, just 1.5%. 

Tomorrow we shall see eurozone PMI numbers, which are a reasonable leading indicator of GDP. Manufacturing, services and composite readings are expected to come in at 59.7, 56.0 and 57.2 respectively, suggesting encouraging signs of ongoing, strong expansion. After years of underperformance, the eurozone is playing a very fast game of catch-up. It was only relatively recently that it was flirting with deflation, but such fears are waning. Unsurprisingly, the euro itself has outperformed against the dollar and, at 1.1750, is up almost 12% against the greenback so far this year.

There is an ECB monetary policy meeting in Frankfurt tomorrow morning. No change is expected, although the market does attach a probability of 19% to a rate hike – albeit only of 10 basis points to -0.3%. Of greater interest, as usual, will be the traditional post-meeting press conference at which Mario Draghi will hopefully provide some further insight into the ECB Council’s monetary thought processes.

As an Italian, Draghi has been taking no chances with the eurozone’s recovery, fearing deflation/unemployment in the south more than the threat of overheating in the north. Even Italy is now beginning to move in the right direction. There, Q3 growth came in at 1.7% compared to the same period last year, up from 1.5% in Q2, although, given the country has experienced virtually no real GDP growth since 2000, this is unlikely to convince the ECB president that an end to ultra-loose monetary policy is required. Furthermore, German inflation has moderated somewhat since earlier this year to 1.8% as of November, meaning that the difficulties created by the ‘one-size-fits-all’ monetary policy remain, for the moment, in check. 

Even the threat of a hard Brexit and its potential adverse impact on European exporters seems to have waned a little, as Britain has made ‘sufficient progress’ to justify moving to the next round of negotiations, which will include trade.

While the European economic picture has taken a turn for the better, the politics still appear somewhat fraught. Angela Merkel’s disastrously mis-handled immigration policy, which has allowed a million ‘refugees’ to enter Germany, led to a large increase in support for AfD in the September election – mostly from Merkel’s traditional CDU/CSU supporters – and has made a coalition extremely challenging for the time being. Merkel could form a minority government but, after three terms, that would be distinctly unappealing for the woman who for so long has been seen to run Europe. It is possible that a grand coalition to include the SPD could be resurrected but the SPD remains uncomfortable with being the junior partner. Alternatively, the CDU/CSU could form a coalition with the pro-business FDP and the right-wing AfD. Merkel has already specifically ruled out working with the AfD, but history teaches us to believe nothing until it is officially denied.

That said, a potential volte-face on Merkel’s part to involve the AfD in any coalition would be a big surprise. This is particularly true given SPD leader Martin Schulz’s comments last week at a party conference in Berlin, suggesting that members should support him in new coalition talks if the SPD can deliver more of what they want in government. This fits neatly with recent calls from German economists to spend this year’s €28 billion fiscal surplus on education, welfare and infrastructure – music to the SPD’s ears. However, were the SPD lured back into government by the promise of such fiscal indulgence, from a democratic perspective, it would raise the thorny issue of the German electorate’s protest-driven shift to the right resulting in an actual policy move to the left under a potential new grand coalition.  

What this might mean for the markets is, as always, difficult to forecast. Merkel has brought a certain stability to the European Project and, by extension, to the euro over the years. Therefore, any lack of stability in German politics – and particularly the threat of another election in the event of an impasse on coalition negotiations – might tempt some participants to sell the euro. However, this would be a mistake. With its negative interest rates, the euro remains an important ‘carry trade’ currency, shorted by traders who then invest in higher-yielding currencies.

For some time this has been the natural, ‘risk-on’ position of hedge funds and political jitters in Germany are more likely to induce the market to go ‘risk off’’, leading to purchases of the  euro as short positions are unwound. Such a scenario would make it easier for Draghi (who is of the opinion that the euro is already quite strong enough) to continue with accommodative monetary policy. In the absence of an unlikely complete political collapse in Germany, this will be a more powerful driver of the eurozone’s economic fortunes than Merkel’s current difficulties. 

 

All views expressed here are the author’s own and are based on information available at the time of writing.

 

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