Stubborn Second Wave

The news flow continues to be dominated by the post-Brexit talks. Even in the face of amped up rhetoric we continue to think a deal is the most plausible outcome, focusing as always on what we think should be the rational calculation by the British Prime Minister in the political realm: in case of “no deal” he would trade a few months of popularity with the most extreme members of his parliamentary group against a mountain of hurdles to electoral victory in four years.

Still, even in Europe the fate of the post-Brexit negotiations will only have a marginal impact on the economic trajectory for 2021 when compared to the pandemic. In the US the current wave remains relentless, making it more likely that the bulk of the impact may be seen in Q1 2021. This makes the continuation of fiscal support necessary to avoid more significant economic scarring before collective immunity is reached. The news flow on this remains inconclusive, even if we still think a compromise will be found between the two main parties. Meanwhile, Europe has cleared a major institutional hurdle on fiscal policy thanks to the deal on “rule of law” implementation struck with Hungary and Poland. The second wave’s damage continues to be concerning though. Most European countries seem to be past peak now, but it is taking more time than during the first wave to normalize sanitary conditions. Germany is about to implement a stricter lockdown from Wednesday onward. The economic impact – already significant in Q4 – is already spilling over Q1 2021.

In these conditions, the ECB had to offer more protection and we think the package announced last week will buy a lot of “peace and quiet” next year on the bond market. Market expectations had gone too far in the days ahead of the Governing Council meeting, but the central bank is still doing the maximum it can within its own constraints. The real question now is on the quantum of monetary support on offer once PEPP stops in March 2022 (at the earliest). Given the ECB’s inflation forecasts, which remain significantly below its target at the end of 2023, the logical conclusion is that the “ordinary” quantitative easing programme will be stepped up. This will be the toughest test on Christine Lagarde in our view. Of course, this sequencing would be jeopardized if inflation surprises on the upside. We take a hard look at this. While fading exogenous shocks should mechanically lift headline inflation next year, we expect little will come from the endogenous sources of price pressure – in particular the state of the labour market.