Euro Area: A Rising Tide Lifts All Boats

The euro area economy faces significant headwinds and is most likely in recession currently. We expect the economy to shrink in both Q4 2011 and Q1 2012.

However, we do expect the recession to be fairly short as headwinds ease and some of them even turn into tailwinds. In particular stronger growth in the US and Emerging Markets will help underpin euro area growth during 2012.

Hence, although the euro area is likely to face slow economic activity for many years, we do expect the recession to be fairly short.

As growth indicators – such as Euro PMI - improve during 2012 it should help reduce global recession fears and underpin an improvement of the current very negative sentiment in the markets.

The main risk to growth remains that the debt crisis deepens and prolongs the recession.

Five reasons why the euro recession will be fairly short

1. US recovery normally leads the euro area
2. Emerging Markets to drive stronger export growth
3. The recession is partly due to inventory build-up
4. Fiscal headwind is significant but is not getting stronger
5. Financial headwinds expected to ease slightly during 2012

#1: US recovery usually leads the euro area

Looking outside the euro area we are increasingly optimistic that the global cycle is turning. One area that has already turned is the US. GDP growth has recovered to 2% in Q3 2011from less than 1% in H1 2011 and current indicators point to growth around 2.5-3% in Q4.

The US industrial cycle has turned as evidenced by the rise in ISM new orders, which has climbed higher in recent months. Historically the US and euro area industrial cycles are highly synchronised as in a globalised world products are produced with components from many parts of the world.

We expect the turn in the US industrial cycle to spill over to the euro industrial sector in 2012. It is quite normal that the euro area industry lags the US cycle as also evidenced by the euro PMI manufacturing index being behind US ISM manufacturing by 2-3 months, but the lag varies in different cycles (see bottom left chart). In fact, there are already signs that euro PMI has bottomed as it has risen two months in a row now.

In the euro area the industrial cycle is also the main driver of the overall business cycle. This means that a turn in the industrial sector will most likely lead to a turn in overall GDP growth, the reason being that the amplitude in the industrial sector is much bigger than in the service sector. The service sector serves as an anchor for the level of growth, whereas the industrial sector causes the swings.

The high correlation between export growth and GDP growth in the euro area (see chart to the right) mirrors the same pattern. The industrial sector is a very open sector and hence the correlation with exports is very high.

Of course the euro area is currently hit by a “domestic shock”, which is depressing domestic demand as investments and consumption are getting squeezed by the tightening of credit standards and high uncertainty. This will push domestic demand growth to a lower level, but the amplitude of the cycle is likely to be driven by exports, which implies that growth is expected to recover when a) global demand recovers and b) the initial negative effect of the “domestic shock” has been felt.





#2: Emerging Markets to drive stronger export growth

Emerging Markets also support euro area growth. Emerging Markets (including China) experienced a significant slowdown during 2011 mainly because higher food prices led to a sharp rise in inflation. Food constitutes a high share of consumption in Emerging Markets (33% in China, 57% in India) and changes in food prices therefore have a fairly strong impact on economic growth. The rise in inflation squeezed growth in two ways. Firstly, real income growth was hit significantly reducing real consumption growth. Secondly, monetary policies were tightened in response to the rise in inflation, which in turn put a further dampener on growth.

However, the strong headwind has turned into a tailwind. Food prices are falling and inflation is coming down fast. This affects Emerging Markets’ growth through the same channels as mentioned above but with the opposite effect: it raises real income growth and it creates room for monetary easing – as already visible in many Emerging Markets.

Euro area export growth is increasingly driven by Emerging Markets and the rapid growth rates have increased focus on these markets. Especially in Germany this has led to a shift in export composition towards high-growing economies such as China, India and Russia. This is a favourable development as future economic growth is also likely to take place in these markets. Today more than 20% of euro exports go to Asia and 18% goes to central and eastern Europe and Russia. In comparison only a little more than 10% goes to the US.

With its strong export exposure to Emerging Markets the euro area has been impacted by the slowdown, but it will also benefit from the expected upturn in Emerging Markets. We expect export growth to Asia to rise to around 20% during the coming quarters from currently being flat measured on a 6-month annualised basis.

The rising dependence on Emerging Markets’ growth is mirrored by the correlation between euro area PMI and Chinese GDP growth (see bottom chart to the right). While far from being perfect it points to improvement fairly soon. As is the case with the US, it reflects that the global industrial cycle is highly synchronised and that the global industrial cycle is increasingly driven by China as the country over the years has become “the factory of the world”.



#3: The recession is partly due to inventory build-up

Some of the weakness in Q4 and Q1 is due to too strong growth in production in the previous quarters.

Whereas US and China saw a significant weakening of growth in H1, the euro area performed quite well. Euro area GDP grew 1.9% (q/q annualised) on average in H1 while US growth was less than 1% and China saw the weakest growth rates since the financial crisis. Part of the rise in production went straight to inventories, though. Especially in Germany companies continued to raise production over the summer despite clear signs that demand was fading. This lifted Q3 growth in Germany to 0.5% q/q, but it also led to inventory build-up.

The inventory build-up means that euro area countries are now in the process of reducing inventories – or at least aiming to do so. This requires production to run below demand for some time and with demand soft as it is, a fairly big downward adjustment in production will be needed to start clearing the inventories. We have already seen the beginning of this adjustment in industrial production data and the low level of PMI – despite the recent improvement - suggest we have a bit further to go.

With inventories being reduced and returning to levels that companies judge appropriate, production no longer has to run below demand. At the same time we expect some improvement in external demand driven especially by Emerging Markets, so we see scope for growth from Q2 and onwards, albeit at low levels.

The PMI index provides some insight in the inventory situation. Judging from these data companies are already cutting inventories of purchased goods, whereas stocks of finished goods have not been reduced to a satisfactory level yet. A good leading indicator for production and orders is the balance between inventories and orders (see bottom right chart). As can be seen the order-inventory balance is at a very low level, but there are some signs of a turnaround which is often followed by economic recovery within a fairly short time. This suggests that we should also see improvement in the PMI order index within the next 3-6 months, which would indicate that the pace of decline in orders is tapering off. PMI new orders increasing above 50 suggests orders are rising again and hard data for German orders are already rising (see chart). If this picture holds we should soon see a rise in PMI order data.



primary budget balance (CAPB). CAPB is the general government budget balance adjusted for the cyclical effect on the budget and interest expenditures. In our calculations we have used the forecasts from the EU Commission released with the Autumn Forecasts published one and a half month ago. The multiplier from fiscal policy to growth is taken from an ECB working paper published in 2009.

Based on these data we estimate the fiscal drag on GDP in 2011 will be 1.5 percentage points falling to 1.0 percentage points in 2012.

The reason for the slight decline is that several countries have already cut back significantly and will do so to a lesser extent going forward. For example, in Spain the CAPB declined from -5.1% of GDP in 2010 to an expected -2.3% of GDP in 2011 – an improvement of 2.8 percentage points. This is a very substantial tightening of fiscal policy. In 2012 the CAPB is forecasted to rise to -1.7%, which is an increase of only 0.6 percentage points implying that fiscal tightening will be less significant. There will still be an effect of the 2011 tightening, but even taking this into account the accumulated outcome in Spain will be a softening– and hence contribute to a lift in the GDP growth rate. It may seem counterintuitive that fiscal policy should lift growth in 2012, but it is because the headwind is easing. It will not disappear until fiscal policy is no longer tightened.

Interestingly enough, Germany also tightened its fiscal policy markedly in 2011. The CAPB is expected to rise to 1.1% (surplus!) in 2011 from -1.0%. This will bring the general government deficit to -1.3% in 2011 and hence well below the 3% limit in the treaty. So part of the reason why growth is slow in the euro area currently is that even the strongest country in the region – Germany – is tightening its policy quite significantly. However, in 2012 fiscal tightening in Germany is planned to ease a bit.



#5: Financial headwinds expected to ease slightly during 2012

Financial conditions tightened significantly in 2011 and provided a marked headwind to growth. Although many of the financial headwinds will persist in the short run we expect overall financial conditions to ease a bit during 2012.

Firstly, bond yields have shot up due to the euro debt crisis. The transmission mechanism from expansionary ECB policy has broken down and although ECB has taken steps to mitigate it, the transmission is still clearly hampered.

The outlook for euro government bond yields depends on how EU and ECB deal with the crisis and how that affects confidence. We believe longer-term bond yields will stay elevated for some time as it will take time to restore confidence. The ECB is reluctant to buy more aggressively, but yields (especially on short maturities) are likely to benefit significantly from the new 36-month LTRO. Banks now have access to much more cheap liquidity and have more eligible collateral. We expect that some of this will be invested in short-term government bonds in the core and to some extent also in the peripheral countries. Moreover, the facilities open up for banks buying back own issues and in general should underpin the liquidity situation of the European banks.

A second headwind comes from tightening of credit standards in response to the more difficult funding situation and as a consequence of the new capital requirements from the EU in which around EUR115bn in new capital has to be raised before mid-2012. Part of this capital is raised by shedding assets and deleveraging faster.

While we believe things are likely to get worse in the short run, we expect some improvement in the second half of 2012. This will affect H1 negatively, but will lend some support to growth in H2. Note that it is the pace of credit tightening that affects the change in the growth rate.

Finally, financial conditions have tightened due to the significant decline in equity markets, which leads corporates to hold back investments. It also raises the cost of capital for companies, which hampers investments as well. In addition, lower share prices have a negative impact on consumers through the wealth effect.

We see scope for higher equity prices in 2012 as markets are still pricing a quite high probability of global recession. As Emerging Markets recover in early 2012 and lift global growth (Emerging Markets drive approx. 75% of global growth), this will dampen recession fears and underpin earnings growth.



Summary: Headwinds should ease during 2012

The euro area economies are plagued by significant headwinds at the moment and the euro area seems to be in the middle of a recession. However, we have reason to believe the recession will be fairly short, mainly because some of the headwinds are going to turn into tailwinds in 2012 in our view. Emerging Markets are expected to boost growth in 2012, the inventory cycle is likely provide temporary headwind to production and the drag of fiscal policy, while continuing to be significant, will not become bigger. Actually our calculations suggest that the drag may ease a bit in 2012. Finally, financial conditions could become less of a headwind during 2012 as equity markets are expected to recover, the 36-month LTRO improves ECB’s transmission mechanism and the credit tightening is expected to ease a bit in the second half of 2012.

Overall we expect GDP to decline by 1.2% q/q annualised in Q4 2011 and 0.4% q/q annualised in Q1 2012 before returning to positive growth rates from Q2 2012 and onwards. The recovery is expected to gather a bit of pace during the year and finish the year with GDP growth around 1.25-1.5%. This is close to but slightly below trend growth, which we see at 1.5% in the euro area.

While the euro area is destined for weak growth for a long time, we do expect the recession to be fairly short. As the recession fades and growth resumes we should see a rise in PMIs and this should help underpin a more positive market sentiment as 2012 progresses. We thus expect PMI to continue higher over the coming quarters.