Massive confidence crisis hitting the euro markets
Focus remained on the euro crisis this week as problems in the Italian bond market continued and contagion spread to Spain and France. Even countries such as the Netherlands and Austria saw their yield spreads to Germany go higher.
Berlusconi kept his word and stepped down on Saturday evening after the austerity package had been passed in the lower house. As expected, Senator Monti (the former EU commissioner) has taken over as prime minister, supported by a ‘technocrat’ unity government. Despite this being an ideal solution from a market point of view, sentiment has remained poor as the ECB’s purchases have been sporadic and with little sign of any clear pattern.
Despite the solution in Italy, the market has been left in a vacuum as the ECB has proven less willing to step up purchases than expected. And this has made the confidence crisis worse. On top of this, the boosting of the fire power of the EFSF seems to be falling apart, the big euro countries disagree on the path forward, and the ECB is reluctant to provide the back stop that the market is looking for. So where is this taking us? We don’t know the exact strategy of the ECB but so far it seems that the ECB won’t let yields rise much above 7% before stepping up purchases. If this becomes a pattern, it might restore some calm in the market as the lack of transparency now is adding to the uncertainty. But uncertainty is extremely high and there is a risk that things could get even worse and spread more severely to credit markets globally. This would be a clear threat to the global recovery where we have actually seen much more positive news lately. The US is tracking 3% growth in Q4 and China is expected to pick up speed as inflation falls rapidly.
Growth in the euro area in Q3 – but heading for a recession
This week Q3 GDP was released and showed a reading of 0.2% q/q in line with expectations. This was unchanged relative to the Q2 growth rate. Growth was driven by the core area, while the peripheral countries weighed on growth. Despite stock markets plunging in late summer and leading indicators beginning to deteriorate, hard data remained relatively resilient during Q3. Industrial production did not give in before September despite the drop in orders setting in before. Also retail sales increased until September, see Euro area: Decent growth in Q3 – don’t get used to it! German GDP increased 0.5% q/q in Q3 and Q2 growth was revised to 0.3% from 0.1% previously. Also French GDP rebounded in Q3 to a growth rate of 0.4% q/q. The Q2 figure was revised down to -0.1% q/q from 0.0%. Looking ahead we think the euro area is heading for recession with a sharp drop in GDP growth of 0.3% q/q in Q4. We forecast a mild recession, but it could become severe if politicians fail to control the debt crisis.
US recovery strengthened further in early Q4
In a week where markets remain focused on the financial meltdown in Europe, there were actually more encouraging figures out of the US. In particular, retail sales (released on Tuesday) were better than expected, with both headline and core (ex. autos and gas) surprising on the upside, gaining 0.5% and 0.6% (m/m), respectively. This bodes well for Q4 consumption, which we expect to track just below 3%, and puts the American retailers in a more comfortable position running up to the Christmas season. In spite of some of the gains in October being due to the launch of Apple’s new iPhone, we still see the past month’s strong retail sales as a sign of underlying growth potential from the American consumer.
Another piece of good news came on Wednesday, when industrial production figures showed a 0.7% gain in October. Motor vehicle production continues to be a large contributor to overall manufacturing production, as the supply distortions from the Japanese earthquake earlier in the year have eased. All in all we are seeing potential for decent manufacturing growth in Q4. With both Philly and Empire manufacturing PMIs showing some weakness, in the headline and details respectively, it could indicate some degree of mismatch between hard data and the surveys we are receiving at the moment – as has been the case for a large part of this year.
Inflation came out very close to expectations, with headline falling 0.1% as a result of declining gasoline prices, while core CPI rose 0.1% in October. Together with our forecast for next week’s core PCE of 0.08%, the overall picture indicates easing price pressure – expanding the wiggle room for the Fed.
China: Decline in house prices intensified in October
It looks as if the decline in Chinese house prices intensified in September. Based on the development in house prices in 70 major cities reported by the National Bureau of Statistics in China, we estimate that house prices declined 0.3% m/m in October after dropping 0.1% m/m in the previous month. This was the fourth consecutive month with a decline in house prices. Still over the past year house prices are up 2.8% y/y. It would be wrong to conclude that the Chinese authorities might be alarmed by these numbers. On the contrary, a minor correction in property prices is just what the Chinese government is aiming for. Nonetheless, it underscores that inflationary pressure is easing and economic policy in China will gradually become more growth supportive. We now expect a cut in the reserve requirement in Q1 12.
Japan: GDP growth surge in Q3, but is poised to slow
In Japan GDP growth surged 6.0% q/q AR in Q3, largely reflecting a fast recovery in the wake of the devastating earthquake and tsunami that hit Japan in March, see Flash Comment – Japan: GDP surge in Q3 as Japan recovers from earthquake. In addition, the contraction in the Japanese economy in the previous two quarters was less than previously reported. Growth is poised to slow in the coming quarters partly due to weaker exports, but Japan is unlikely to slide into a new recession because reconstruction will continue to support growth. In our view, GDP growth will slow to around 2% q/q AR in Q4 and improve close to 3% q/q AR in Q1 12.
As expected, the Bank of Japan (BoJ) did not announce new easing measures in connection with this week’s monetary meeting, see Flash Comment – Japan: Bank of Japan on hold, still sees substantial downside risk. However, in its statement, it said that the recovery following the earthquake will moderate and BoJ continues to see substantial downside risk due to the international development. Importantly, BoJ still cites adverse impact on the economy from the strong JPY, suggesting that Japan will continue to intervene in the FX market to stem the appreciation of JPY and possibly back up the intervention by further quantitative easing.