Don't bank on investment

Sustainability of the recovery is what central bankers around the world want to see before starting to reduce monetary accommodation. In this respect, business investment is the key variable to monitor, as it represents the link between an export and policy-led recovery and a more sustainable growth dynamic that involves the labor market. This issue of the Euro Compass therefore has a strong focus on investment.

The bottom line of our analysis is that fundamentals point to further capex contraction in the coming quarters, and we therefore continue to expect a stabilization of business investment no earlier than mid-2010. This should allow the ECB to keep the refi rate at 1% throughout next year. Recent positive surprises on the real economy front and in financial markets may pose some upside risks to our baseline scenario.

We note that uncertainty regarding the capex outlook is extremely high at this stage because different indicators deliver conflicting messages. Business surveys have rebounded strongly from their lows, with relatively bullish implications for future investment plans. However, still weak loan demand and extremely depressed capacity utilization suggest that capex contraction could continue for most of next year, if not longer.

We analyze the financial position of the eurozone corporate sector, focusing on how the recession is hitting profitability and balance sheets. We show that financial constraints stemming from lower internal cash flow and high indebtedness will result in an increased need for deleveraging. In turn, this will be a serious drag on investment, increase firms’ vulnerability and inhibit the economic recovery. This is confirmed by the results of a Tobin’s Q analysis, which also indicates that firms’ incentives to invest have weakened substantially.

We take a look at the possible sources of near-term upside surprises on CPI and claim that, apart from oil, it is administrative prices that have the largest potential to overshoot compared to our forecasts. However, their limited weight implies that the impact on inflation should be contained. In the next three to six months, ex-oil factors are therefore unlikely to trigger any major revision to the inflation path trough end-2010.

We analyze the reasons behind the outstanding outcome of the June 1-year LTRO. We forecast an allotment in the EUR 125-175bn area for the September 29 LTRO. Then, resorting also to ECB research, we try to dismantle some mantras on the euro area money market that have accompanied us over the last two years.

A careful analysis of the BoE’s conduct of monetary policy suggests that ongoing criticism of the effectiveness of the central bank’s QE program is not justified, given that the program is working. Therefore, we do not expect that Governor King’s recent remarks will portend any imminent decision on the rate of remuneration of banking reserves.

In the bond market, with investors still debating the timing of the exit strategy, we expect 4Q to be volatile without a clear trend. We see a moderate increase in long-term yields, which should keep the curve steep. Abundant liquidity and carry trades will sustain the front end.

Trends on FX majors will again remain a risk appetite/risk aversion story, at least throughout 1H10, as key policy rates will remain mostly on hold worldwide. Expect then a firmer EUR-USD above 1.50, before some mild pullback in 2H10.