After an initially negative reaction to the election of Donald Trump as U.S. President, European markets rebounded swiftly. Contrary to the effects seen after the Brexit vote, stocks rallied and the flight to safety unwound very quickly. The euro, after initially appreciating against the dollar to reach $1.13 on Nov. 9, fell back to $1.09 at the end of the day. Similarly, the Swiss franc, considered a safe haven asset, depreciated by 0.7% against the dollar after its initial 3% jump earlier in the day. The German Bund, also considered to be safe asset, remained stable, with yields at about 0.1% (see chart 1). Meanwhile, the Stoxx Europe 600 index closed up in deeply positive territory at +1.5% and the British FTSE index was up 1.0% on the same day.
Trump's Win Is Brexit Plus
We nevertheless think more volatility in markets is still likely because uncertainty about how President-elect Trump will govern is blurring the full economic impact. His economic agenda remains difficult to quantify. It is unclear, for instance, whether his anti-trade statements will in reality lead to protectionist measures. What's more, if fiscal policy is likely to be more expansionary, the newly appointed president's government spending proposals could be constrained by existing budget rules and debt limits. We therefore view the U.S. election outcome as another "uncertainty shock" comparable to the U.K. referendum decision to leave the EU. In theory, if policy uncertainty continues, there could be a real cost to economic growth, affecting investment, hiring, and consumption decisions.
One direct and immediate consequence in Europe of Mr. Trump's win is likely to concern monetary policy. One reason why the financial market turmoil following the U.K.'s decision to exit the EU has so far had only few consequences for European growth was the swift reaction by central banks, which prevented the financial turmoil from spreading. Similarly, we view the uncertainty created by the U.S. election outcome as a factor likely to encourage a more dovish tone and action from the European Central Bank (ECB). We therefore now view a tapering of bond purchases by the ECB as further off than we previously expected. We consider the QE tapering will not start before the end of 2017, and we still expect the ECB to announce in December it will extend its asset purchase program further in March 2017, along with technical measures to deal with eligible bond scarcity.
Eurozone Recovery Will Be Tested By More Political Risks
Meanwhile, the current recovery in the eurozone seems to be still on track. Real GDP in the euro area expanded by 0.3% quarter on quarter in Q3, after a similar pace of growth in Q2, and 0.5% quarterly growth in Q1. The monetary union has proven particularly resilient since mid-2013, despite a difficult political and economic environment. The economy has continued to grow at a steady rate of 0.3%-0.4% in spite of a long series of shocks, including growth concerns of emerging economies, the refugee crisis, Brexit, and repeated flare-ups in banking system tensions.
France and Spain have already released their GDP growth figures for Q3. According to preliminary estimates, Spain's real GDP rose by 0.7% and France's by 0.2% quarter on quarter. Looking forward, economic indicators continue to point to similar moderate GDP growth in the last quarter of 2016. While October's final eurozone composite Purchasing Managers Index (PMI) survey was revised down slightly from 53.7 to 53.3, this is still at its highest level since January (a reading of 50 or higher generally indicates that the economy is expanding ). However, political risks are clouding the horizon. An important constitutional referendum in Italy on Dec. 4 represents an immediate source of uncertainty. It could trigger a political crisis benefiting the populist party Five Star movement. The year 2017 also has a busy electoral calendar, with general elections in the Netherlands, France, and Germany. Anti-establishment and populist parties have been encouraged both by the Brexit vote and the U.S. election outcome.
Inflation Is Key To The Future Of QE
Eurozone annual inflation inched up to 0.5% in October, entirely driven by the rise in energy price inflation. The pace of this increase is expected to strengthen in the coming months, as a base effect will contribute to lifting energy price inflation meaningfully. Overall, rising inflation is good news for the ECB, as it suggests that its monetary policy is gradually lifting inflation towards its target of below, but close to 2%. Further rises in inflation are likely to push bond yields higher. The upward trend has already materialized, with yields on German Bunds in the past week in positive territory and at their highest level since last May.
However, core inflation (excluding items with particularly volatile prices, such as energy) has been remarkably stagnant since May, hovering around a tight range of between 0.8% and 0.9% . This is in spite of the lower output gap in the monetary union, reflected in the steady decline in the unemployment rate (see chart 2). Since the start of 2015, the ECB's Governing Council has repeatedly stated that any decision to end QE would be based on a "sustained adjustment in the path of inflation". If the recovery in inflation is to be sustained, core inflation will have to pick up meaningfully, and this would come from a pick-up in wage growth. However, this has not been the case so far, even in countries close to full employment, like Germany. Worse, German wage growth slowed in the first half of 2016. The impact of a tight labor market on wages seems to have been constrained by a significant mismatch between the qualifications of the unemployed and those sought by employers. Looking forward, moderate wage agreements in 2016 on average suggest only 2% wage increases in 2017. Modest wage growth trends would then keep core inflation below the ECB's target, in our view.
Moreover, market-based measures of long-run inflation expectations remain at a relatively low level. The 5-year/5-year euro swap rate inched up only two tenths to 1.47% from its September trough of 1.28% (see chart 3). This rise is due to several factors, including the rebound in the oil price, but also the markets' belief that core and headline inflation will accelerate towards the end of the year. However, markets don't seem to be convinced this acceleration will be protracted or reach inflation of 2% in the medium term.