Expectation. As the new year draws ever closer, uncertainties could hardly be greater. The sovereign debt crisis has also become a financial sector crisis and is starting to threaten the non-financial private sector, as well as social cohesion in some countries. Nevertheless, we remain confident that the European economy will bottom out this winter, followed by moderately better growth towards about 1.5% annualized at the end of 2012.
Determinants. Slower global growth, harsh austerity policies and the tight financing environment in the periphery will limit the pace of recovery. Support should come from improving purchasing power (moderating inflation), more generous liquidity measures and a gradual defusing of the crisis of confidence in the course of 2012. Demand from Emerging Markets should also recover.
Forecasts. The weak start into the year should result in EMU-wide economic growth averaging 0.6% in 2012 ( which is above consensus); however, for 2013, we expect real GDP to grow again by 1.6%. Germany will remain at the top of the growth league while Italy will lag behind.
ECB. If our baseline scenario of no recession proves correct and leading indicators turn north again by the end of winter, this should weaken the case for cutting the refi rate below 1%. A slowdown in credit dynamics, moderating inflation and an impaired transmission mechanism do make this expectation a close call however – particularly if the ECB remains timid on the SMP.
Risks. In that case, the confidence crisis will last longer than hoped for. In terms of political or event risks, our outlook bears more downside than upside risk. But we also see the possibility of a positive surprise: If policymakers “deliver“ and the ECB reacts more aggressively, this could result in a virtuous cycle. On this note, we wish you:
EMU: A soft patch followed by a slow recovery1
The eurozone is heading towards a moderate GDP contraction in 4Q11, but we do not see this as the beginning of a technical recession. As a matter of fact, some business surveys already show signs of bottoming out.
This leaves us comfortable with our “soft patch” story, although our call relies on the assumption that sovereign tensions will abate next year. In yearly average terms, following 1.6% expansion in 2011, we forecast GDP growth of 0.6% in 2012
Fiscal policy and higher capital requirements for banks will be a drag on growth next year. We try to quantify their impact on GDP. We also look at the credit cycle, and argue that lending to the private sector should start weakening in the first months of 2012 and bottom out in early 2013.
The ECB enters 2012 with a clear easing bias. However, given our view of no recession, the refi rate should remain on hold throughout 2012.
There are several downside risks to this call: the expected slowdown in inflation and credit growth is one of them. Also the impaired monetary policy transmission mechanism poses downside risks. If markets remain tense and the ECB does not step up its govie purchases, policy rates will very likely head lower next year.
More aggressive (and conditional) ECB purchases of sovereign debt remains the easiest and most effective way out of the crisis, and probably the least expensive for the balance sheet of the central bank.
Soft patch, no recession
In the eurozone, 2011 closes with most survey indicators signaling a high probability of mild GDP contraction at year-end. However, hard data continue to come in somewhat firmer than implied by sentiment indicators, confirming a trend that has been in place for the last few months. This leaves us comfortable with our long-held view that although the eurozone economy is going through a “soft patch”, it is not falling off a cliff. We forecast a 0.2% qoq GDP drop in 4Q11 – the quarter that will probably see the largest impact on business and consumer sentiment from the market turmoil that started this summer.
However, we remain more optimistic than consensus and think that the euro area will be able to avoid a recession, yet we are aware that this scenario relies heavily on the assumption that sovereign tensions will abate over the course of next year.
In our baseline GDP scenario, we assume a sustainable decline in Italian and Spanish government bond yields already starting early next year, followed by tangible relief for the European banking sector as a whole and, in turn, an improvement in sentiment indicators across the economy. We do not think there will be one specific trigger for this improvement, but the accumulated effects of policy adjustments and the signs that the real economy is bottoming out – and with expectations that the banking system will meet the 9% core Tier-1 capital threshold by mid-2012 – markets would presumably start to adjust. It is certainly difficult to imagine another year in which 90% of the world’s bond funds underperform and the hedge fund community delivers negative returns to their investors.
If we have some relief in financial markets, still solid private sector fundamentals – particularly at the corporate level – and some revival of demand from emerging countries, should be sufficient to put the (moderate) recovery back on track. In our baseline scenario, we are nearing the trough and growth will resume at the beginning of 2012, gradually re-accelerating over the course of the year and into 2013. Capex should contract short-term, but thereafter will probably react relatively quickly to the expected improvement in economic conditions. In contrast, the upside potential for private consumption seems quite limited for next year, as employment growth will falter and the fiscal stance will remain restrictive, leaving slower inflation as the only support for real disposable income.
In yearly average terms, following a 1.6% expansion in 2011, we forecast GDP growth of 0.6% in 2012 and 1.6% in 2013. These aggregate numbers hide a heterogeneous picture: among the largest economies, next year Germany is expected to outperform (+1.2%), while Italy will likely lag behind (-0.3%) due to the mix of fiscal austerity and tight financial conditions.
Fiscal policy is the single most important dampening factor for economic growth in the years 2011-2013. However, as the fiscal stance in 2012 will be very similar to 2011, austerity will NOT be responsible for the severe GDP slowdown envisaged in 2012, which will be mostly driven by easing in global growth and the intensification of financial tensions recorded in 2H11. Similarly, given that the drag from budgetary consolidation will be lower in 2013 than in 2012, the fiscal stance will contribute positively to the growth acceleration expected in 2013. In general, the size of fiscal tightening across the eurozone is easy to compute as the sum of individual countries’ fiscal plans, but its aggregate impact on economic activity is extremely uncertain. The table shows the size of the consolidation announced so far in the largest eurozone countries as well as periphery, together with the estimated GDP drag area-wide. In our projections, we have assumed a fiscal multiplier of 0.5 – mostly to reflect the mix of higher revenues/lower spending planned for in national budgets – but we think that risks to this estimate are in both directions.
On the downside (i.e. higher multiplier), simultaneous belt-tightening measures across trading partners may increase the drag on GDP, particularly if monetary policy has only limited room to react to the restrictive fiscal stance. On the upside (i.e. lower multiplier) consolidation could bite less than expected if austerity helps weaker countries regain market confidence and thus reduce debt-servicing costs – particularly if credible fiscal policy triggers ECB intervention leading to lower sovereign bond yields. In a favorable scenario, we can expect the fiscal multiplier to be as low as 0.25, while in an unfavorable scenario it could reach 0.75. In the former case, austerity would dampen GDP by 0.3-0.4pp in 2012 and by 0.2-0.3pp in 2013, whereas in the latter case, the drag would be 1pp next year and 0.7-08pp in 2013.
Higher capital requirements will weigh on GDP, but not excessively. The EBA’s recently updated estimates indicate that the banking sector will need EUR 115bn of additional capital to reach a 9% CT1 ratio by the middle of 2012. Using estimates provided by the IIF to gauge the impact of Basel III on economic growth, we find that EUR 115bn of higher core capital requirements (in a “rapid adjustment scenario”) would lead to an average drag on GDP growth of approximately 0.1pp a year, with 2013 likely to be more affected than 2012. This can be considered as a lower bound for the GDP impact of new capital requirements. However, the drag on growth would increase substantially if we assume that a higher core Tier-1 ratio is essentially achieved by balance-sheet shrinking. In this case, for every 1pp increase in the total equity/total assets ratio achieved with a 25% contribution of capital rising and a 75% contribution of asset shrinking, we estimate that credit growth could drop by about 8%. According to ECB calculations, this credit contraction could have a cumulative impact on GDP of about -0.7pp. We see this as an upper bound. In our baseline scenario, we assume that the adjustment towards higher capital ratios will occur mostly by capital being raised. Overall, we expect higher capital requirements/deleveraging to shave about 0.1-0.2pp off GDP growth in 2012 and 0.3pp in 2013, but uncertainty surrounding these estimates is high.
Higher capital requirements will most likely negatively affect banks’ willingness to lend, but at least three other factors argue for a weakening of credit trends during 2012. To some extent, this will be the price paid by the private sector in the peripheral countries for the ECB having lost control of monetary policy (as the transmission mechanism became impaired) over the last 18 months:
1. Bank credit standards move in tandem with two of their main determinants, namely changes in economic conditions (as measured by the composite PMI), and banks’ cost of funding (proxied by the iTraxx financials). Given our view that business surveys will bottom out in the next couple of months, while banks' funding pressures will start easing as early as 1Q12, we expect that the tightening of credit standards recorded this summer will intensify between late 2011 and early 2012.
2. The long lag of about four quarters between the peak in the net tightening of credit standards and the trough in credit growth, as measured by the yearly growth rate of lending to the private sector (currently at 2.7%).
3. Household lending, the first credit aggregate to turn, entered a slowing trajectory in mid-2011. In previous cycles, the average lag between the turning points in household lending and overall lending to the private sector was three quarters.
We therefore expect lending to the private sector to start weakening in the first months of 2012 and to bottom out after about one year. However, we are aware that higher capital requirements in a context of funding stress can potentially alter the lags of this credit cycle compared to the past. The extent of the credit deceleration is even more challenging to forecast because, on the supply side, credit growth will depend, on the one hand, on banks’ deleveraging strategies and, on the other hand, on the effect of the unprecedented liquidity measures recently put in place by the ECB (particularly the 3Y LTROs). Given the very subdued starting point, it would not be surprising to see credit growth numbers turning negative as we approach the trough of the lending cycle.
ECB: Rates on hold, but with increasing chance of additional easing
The new ECB macroeconomic forecasts unveiled on 8 December, envisaging substantial downside risks to the growth outlook, indicate that the central bank is more bearish than us and enters 2012 with a clear easing bias. However, the decision to cut rates in December was not unanimous, implying that the GC may wait another couple of months before re-assessing the case for further easing. If our baseline scenario of no recession proves correct, by February/March most leading indicators should have started to turn, persuading the ECB that no further downward revision to the GDP/CPI outlook is needed. In turn, this should weaken the case for cutting the refi rate below 1%, although inflation hovering at around 2% (from 3% currently) and the expected slowdown in credit dynamics are certainly consistent with another one or two rate cuts during the course of 1H12. One additional source of uncertainty is the fact that Euribor rates are adjusting very slowly (too slowly) to lower policy rates, implying that the transmission mechanism of monetary policy remains highly impaired.
On the one hand, this strengthens the downside risks to our refi rate call but, on the other hand, shows that more radical ECB action is definitely needed on the govie purchases front. If we are wrong and the ECB does not deliver on the SMP, policy rates will very likely head lower next year. In terms of economic variables (e.g. exchange rates and commodity prices), our outlook is well balanced with respect to risks. However, in terms of political or event risk, our outlook suffers more from downside than upside risks.
That said, political upside risks do exist. If national governments continue to take their dose of painful adjustment, and the pan-European response to the crisis moves in the direction of the fiscal compact agreed in principle by the summit in December, then it is still possible that the ECB will move more aggressively to restore the transmission mechanism by beefing up its purchases of sovereign debt. We would expect a powerful positive chain reaction as market participants observe the change of heart at the ECB, involving sovereign spreads, banks’ cost of funding, business and (to a lesser extent) consumer sentiment. This remains the easiest and most effective way out of the crisis, and probably the least expensive for the central bank's balance sheet.
But it is also possible that the economy will remain relatively flat for a longer period of time, that the participating governments fail to implement the fiscal compact, and that the ECB’s attempts to restore the transmission mechanism via liquidity to the banking system does not really work – and that the ECB remains too timid on the SMP. In that case, we expect a long and painful 2012, with huge volatility and increasing risk of a potentially catastrophic development in the financial system.
