Signs of life: The eurozone’s longest recession to date is finally over and signs of recovery are becoming more convincing, even in the periphery. But any upside surprise to growth will need to be large and sustained in order to lower debt burdens and alter the downward trend in inflation.
Another recession is over
The recent raft of better-than-expected data from the eurozone has led to a distinct brightening of sentiment towards the region that has been missing for much of the past few years. The stabilisation in unemployment in June, improving consumer confidence, a robust increase in June industrial production, a stronger-than-expected rise in the July PMIs, together with the confirmation in the Q2 GDP release that the eurozone’s longest recession (six quarters) to date is finally over, all support our view that the expansion in eurozone GDP is set to continue in the second half of the year.
So there is plenty of good news – news that has helped to drive sovereign bond spreads in the periphery to two-year lows.
However, as we have consistently stated, we do not believe that the types of growth rates that materialise over the next two to three years will be strong enough to stabilise debt burdens in many member states, nor that they will lead to any pick-up in inflation.
Nonetheless, given the upside surprises that have already occurred in actual UK GDP growth and the recent positive surprises in many eurozone indicators (including the upside surprise to Q2 GDP), we take a quick look at where any upside surprises to eurozone growth could come from in the second half of this year.
Possible upside risks…
Industry and exports
It is in the industrial sector that the improvement in eurozone activity has been most convincing recently and where any upside surprise to growth in the coming year is most likely to come from. Overall eurozone industrial production registered a reasonable expansion again in Q2 (1.2 per cent q-o-q) and the survey data for July point to ongoing growth in Q3 and a growing likelihood that the expansion extends beyond the likes of Germany (2.6 per cent q-o-q in Q2) and France (1.4 per cent). There were some signs of improvement in the periphery, particularly Ireland (+3.5 per cent q-o-q) and even Greece (+0.8 per cent q-o-q), but Italian production fell 0.9 per cent q-o-q in Q2 and Spanish production was flat.
As usual the industrial expansion will have to be largely export-led so the global environment is still critical and there are some downside, as well as upside, risks there too. Our Asian economists recently became a little less optimistic on the prospects for growth in China and in Asia generally). This will have implications for German exports in particular: German nominal exports fell slightly in y-o-y terms in the first half of this year but it would be wrong to assume that Germany’s exports to Asia face a persistent downward slide.
Indeed, having fallen back sharply late last year, Asia recently became a driver of German export growth again, as did the US, as can be seen by looking at export growth on a quarter-on-quarter basis.
Hence, exports of goods and services contributed positively to German GDP in Q2 and, according to our calculations, to eurozone GDP.
Peripheral exports proving resilient
It wasn’t just Germany that was hit by the slowdown in Chinese import demand over the past year, the periphery was hit too. But China accounts for a much smaller share of their exports (1.7 per cent in Spain vs six per cent in Germany) and the periphery continued to benefit from the strength of other emerging markets, notably in Africa and Latin America, which helps to explain why Italian and Spanish export orders in the PMIs have seen a stronger revival than that of Germany in recent months (chart 2).
Improving competitiveness is probably also playing a role in some peripheral countries, such as Spain and Portugal as their exports have performed better than other member states even in markets such as Germany and the US this year.
Full details for Q2 GDP are not yet available but we estimate that exports were a key driver of Spain’s smaller-than expected contraction (-0.1 per cent q-o-q) and Portugal’s remarkable 1.1 per cent q-o-q rebound in GDP in Q2.
Less fiscal contraction
The eurozone is still tightening fiscal policy and further cutbacks on government spending will continue at least in 2014 and 2015 in many eurozone member states. Nor can further tax rises be ruled out, even in the second half of this year.
In Italy the latest VAT rise has been persistently postponed and is now slated for October.
But, overall, the scale of the tightening is lessening, particularly since the European Commission agreed in June to give a number of countries an extra two years to hit the three per cent of GDP deficit target.
Public investment spending has already been cut to the bone and the pace of public sector job shedding could well ease a bit, but the public sector is only likely to add to growth in Germany, Austria and France.
Across the periphery it will remain a drag, but only in the case of Cyprus and Slovenia is there likely to be bigger a fiscal contraction in 2013-14 than in 2012.
Consumer spending has already seen some signs of improvement. As we highlighted in our latest quarterly, the squeeze on real wages over the past three years has finally abated due to the energy-induced slowdown in inflation .
This is most marked in Germany where annual real wage growth was running at close to two per cent y-o-y in Q2 but falling inflation also allowed it to turn slightly positive in Italy despite the ongoing wage moderation.
Should the next Italian VAT rise be delayed further it would be a welcome relief for Italian consumers. Elsewhere in the eurozone, the hit from indirect taxes will be fading later this year.
Together with the tentative signs of improvement in the labour market and general improvements in confidence, this has fed through to some stabilisation in spending after the sharp cutbacks late last year.
As the Q2 GDP release was just a flash reading we have little detail: the detailed eurozone release will be published on September 4 and we expect consumer spending to show a small expansion driven by Germany and France. Some information on the other member states can be gleaned from the retail sales data.
These are notoriously volatile in the eurozone and can sometimes differ significantly from national data on broader consumer spending (as they do not capture spending on, for instance, energy consumption and other services) but they still provide some indication of the direction of spending on a cross country basis.
The Q1 rise in eurozone retail sales retail sales was driven largely by Germany but the same rate of expansion registered in Q2 was driven by France and Spain.
Much now depends on the outlook for the labour market and while we believe that the worst of the adjustment is behind us we are not convinced that the June data, which showed a stable eurozone rate and a drop in unemployment in all of the peripheral countries, is the beginning of a trend. We still expect a gradual upward drift in the eurozone unemployment rate over the next few quarters which will limit the upside for household spending.
Consumer confidence is well off its lows in much of the eurozone but the “intention to buy” series has not recovered (chart 4) although it has in Germany, where employment is already showing a more sustainable expansion and the household savings rate is falling (10 per cent in Q1).
There are also finally signs of a nascent recovery in new lending to households in Germanywhereas in the likes of Spain the best that can be said is that the pace of deleveraging is starting to slow.
Asia recently became a driver of German export growth again, as did the US
Investment is still the main area of weakness in the eurozone, with even German machinery and equipment remaining much weaker than would be typically expected given the export performance over the past few years. (We suspect the Q2 rebound in German investment was primarily a weather-related construction rebound after the very weak Q1.)
This suggests there may be an element of pent up demand that could start to come through in the second half, assuming the crisis remains under control and confidence continues to recover. There is so far little sign of companies looking to borrow more for fixed investment.
Indeed debt restructuring remains pretty much the only demand for loans that eurozone banks are currently facing, according to the ECB’s bank lending survey.
Admittedly, that survey probably tells us more about the SMEs and less about the listed companies, who tend to rely on capital markets so it may not capture the full picture.
As with consumer spending, an upside surprise to investment spending is more likely to come from Germany than the periphery where the banking systems still do not appear well placed to facilitate a strong recovery and ongoing uncertainty about future demand is likely to remain a constraint.
Nonetheless, exports from the rest of Europe would clearly benefit from a better than expected German rebound, whether they are tied into to the German manufacturing process or domestic demand.
Downside risks too
We have so far focused on the upside risks which stem mainly from the industrial rebound being better than expected. There are also plenty of downside risks (many of them structural, political and institutional) which we have written about many times before so we won’t dwell on them here.
The key near-term external risk which could hit the recovery is still the impact of the Fed starting to taper its asset purchases. Our US economists’ view that the Fed is more likely to wait until December to announce the beginning of tapering is less worrying for the eurozone than the consensus view that it will start in September.
Nonetheless our measure of eurozone financial conditions is already looking less supportive in y-o-y terms than it was earlier this year. So far most of this impact has come from a stronger euro (chart 4), which has risen about 10 per cent in trade-weighted terms over the past year.
But real rates (short and long) are now also slightly higher. The drag from the latter would be expected to become bigger in the event of Fed tapering but should not be enough to derail a modest eurozone recovery in the coming year, unless it leads to a marked slowdown in the US (our US economists still expect an acceleration in US GDP into Q4 and 2014) especially as the impact of higher long rates is expected to be partly offset by some weakening in the euro (our FX strategists forecast UR:USD at 1.24 at end-2013.
Broader growth in the second half…
Now that the recession has ended, the good news is that the expansion is set to continue in the second half and, in Q3 at least, the divergence should narrow.
German growth is set to slow a little (to quarterly growth rates of 0.3 per cent-0.4 per cent on our existing forecasts) as the industrial expansion continues but the weather-related construction rebound of Q2 fades.
We also expect French growth to moderate from the unexpectedly large 0.5 per cent q-o-q rebound in Q2 as energy consumption was boosted by cold weather in Q2 and the negative impact of tax increases is set to increase again in the second half.
However elsewhere we should see further signs of stabilisation. We expect growth in Italy to turn slightly positive in the second half.
We always expected a second half recovery and whereas earlier this year the risks to our GDP forecasts (-0.6 per cent in 2013 and +0.6 per cent in 2014) were tilted to the downside, they now appear tilted to the upside in the near-term.
Obviously this is welcome and, after the prolonged period of contraction, even a stabilisation in activity could bring large benefits to companies operating in Europe whose earnings growth has been entirely contingent on their ability to continue curbing costs. We will not be making any explicit revisions to our forecasts until the full details of the Q2 GDP data are published on September 4.
At this stage we do not consider that the potential upside risks to eurozone growth are of a magnitude that will significantly alter our medium-term structural view that government debt burdens will continue to grow and inflation will remain under downward pressure.
. . . but it needs to be stronger and sustained
As the new Bank of England Governor, Mark Carney, reminded us last week when he explained the Monetary Policy Committee’s new forward guidance policy for the UK, eliminating the slack in the economy will require sustained growth.
The same point applies to the eurozone. Extrapolating recent trends can be dangerous. This is not the first recovery the eurozone has had since the deep 2008 downturn: from mid-2009 it recovered for two years but in many member states it was not strong enough to lead to a drop in the unemployment rate even in some of the countries where growth was briefly above trend (such as Italy).
A sustained period of above-trend growth will be required to significantly lower the unemployment rate and without such an improvement in the labour market it will be very hard to put the public finances back on a sustainable path.
Given our view that growth in much of the eurozone, and especially in the periphery, will be largely export-led, we expect it to be very cyclical and therefore likely to undergo renewed periods of slowdown every time world trade dips.
This implies that the very high level of unemployment will fall only gradually in many member states, resulting in persistent downward pressure on wage growth.
So, while the growing confidence in a second half recovery is allowing the ECB to pause for breath we still believe it should spend the time examining the other options it still has in its toolkit.
The commitment to the OMT has succeeded in curbing the crisis by eliminating the FX risk but, in our view, it is only a matter of time before the ECB will need to consider further monetary easing in order to address potential downside risks to price stability.
Janet Henry is chief European economist at HSBC Bank plc.