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Mounting recession risks in Europe

Fri, Aug 1 2008, 13:00 GMT
by HVB Group Global Markets Research

HVB Group

• Downturn. After starting the year on an unexpectedly strong note, growth in the eurozone has weakened massively. In spring, GDP throughout the EMU should have stagnated at best. That is also the message from our GDP model primarily based on hard economic data (cf. chart). Even worse, the risks are clearly tilted to the downside.

• Widespread. The German economy probably even contracted in the second quarter. And while gross domestic product in France and Spain posted at least slight growth, the Italian economy should have treaded water during spring.

• Stagnation. The rapid slowdown in growth is, however, more than just a technical correction in response to the strong first quarter. Our composite PMI points to only minimal growth for the summer, too. And there is unlikely to be much change in this situation in the quarters to follow. The best-case scenario is, therefore, that the eurozone will just scrape by a recession (pages 2-3).

• ECB. Rate hike speculation is, therefore, off the table. In fact, the ECB will soon have to scale back appreciably its so far relatively confident growth expectations. Then at the latest by year-end, markets will price in rate cuts, which the ECB will deliver from next spring on, when inflation as well as money supply growth should have decelerated (p. 4-5).

• Further topics:

  – US reacts to flare up of financial market turbulence (page 6).

  – Commodity markets: Correction, but no trend reversal (page 10).

  – Data outlook: Fed, ECB & BoE to hold interest rates steady (p. 13).

  – Market outlook: Government bonds to remain in demand; EUR to continue to weaken (p. 21).

EMU: GDP growth at a standstill

• In the eurozone, the last two months have seen increasing signs of an abrupt loss of growth momentum.

• After a whopping Q1, GDP growth probably corrected sharply and was at best flat in the second quarter. The slowdown should have involved all countries, with Germany leading the pack in the downward adjustment.

• The outlook for Q3 is grim. In July, the composite PMI fell to a level consistent with only 0.1% q-o-q GDP growth. All sectors are under pressure, but manufacturing and consumers seem to be in particularly bad shape.

• Despite mounting downside risks, our baseline scenario remains one of very sluggish growth for several quarters, but no technical recession. The recent pullback in oil prices could be a welcome breath of fresh air.

• The ECB will have to take stock of the deteriorated growth outlook and remain on hold for long. The next rate move is likely to be a cut, sometime around mid-2009.

Q2 GDP: At best flat

If things play out favorably, eurozone GDP growth will be flat in the second quarter after having expanded by a strong 0.7% in Q1. However, the risk of an outright contraction is very high, and we would put it at no less than 40%. With all hard data already available up to May and some June releases already out, it’s striking that virtually all the components of our GDP Tracker show negative growth in the second quarter (cf. chart). While a sizeable "payback" in construction output was in the cards after a formidable (mostly weather-related) performance in Q1, the weakness underlying industrial production, retail sales and car registrations is more genuine, and consistent with the gloomy message delivered by most business and consumer surveys.

The demand breakdown risks being as disappointing as the overall GDP figure: we assume that private consumption was flattish, fixed investment shrank and exports slowed substantially (however, thanks to easing imports, net trade should be roughly neutral), making Q2 a quarter of widespread weakness. At a country level, German GDP is expected to fall into negative territory after the whopping 1.5% q-o-q of the first quarter. We currently forecast -0.2%, but risks to this estimate are on the downside. For France, we have penciled in a slowdown from 0.5% to +0.2%, but also in this case we see concrete chances of a weaker outcome. Italy should have stagnated, and Spain expanded by a tiny 0.2%.

Q1 & Q2: Take them together

Right after the release of the strong Q1 GDP number, it was quite clear that similar strength was not sustainable, and that Q2 would have seen a correction, not least because the first quarter was buoyed by some positive one-off factors set to unwind in the following three months. The ECB itself has stated several times that “Q1 and Q2 need to be taken together”. Therefore, the question was not if, but by how much the economy would have slowed down in the second quarter. Our Composite PMI – probably the simplest and most reliable tool to assess GDP trends in a timely way – points to easing momentum and is consistent with 0.35% q-o-q growth in Q1 and 0.30% in Q2 (cf. chart), which is worth a cumulative 0.65% in H1 2008.

If we assume that the relationship between the PMI survey and actual growth remains valid despite the (often elevated) volatility in quarterly GDP, then 0.7% q-o-q growth seen in Q1 needs to be followed by either a flat or marginally negative number in Q2: this is exactly what seems to have happened.

Q3 started off on the wrong foot

If an abrupt GDP slowdown in Q2 had to be expected, the most recent developments certainly suggest that growth weakness goes beyond a technical correction. In particular, we regard the further drop in July PMIs as a worrisome signal, for two reasons:

– both the factory and the services sector indices are on a steep downward trend and currently stand well below the 50 threshold, implying that the downturn is becoming increasingly broad based.

– France, which we previously identified as a sort of swing state for the fate of the eurozone, is quickly moving toward stagnation. One after the other, all large economies are capitulating (Italy and Spain were the first ones to fall).

In detail, the eurozone manufacturing PMI in July fell to 47.5 vs. the previous 49.2 (cf. chart), a level that is consistent with a 3.5% annualized drop in industrial output. Weakness was broad based across components. Most notably, production fell to 46.9 and new orders sank to 44.0, both reaching the lowest level since end-2001. Concurrently, stocks eased only marginally, implying that the new orders-to-stock ratio declined to its lowest level since October 2001: we read this as a clear indication that production will remain under significant pressure in coming months. To make things even worse, the employment index fell further below the 50 threshold.

The outlook for the tertiary sector is only marginally less negative. In July, the services PMI fell from 49.1 to 48.3, with business expectations dropping to the lowest level on record. Employment fell below 50 and hit the lowest level since mid- 2004.

As a result, our EMU composite PMI fell one full point to 48.1, consistent with 0.1% q-o-q GDP growth at the beginning of Q3. Growth momentum has virtually come to a halt.

Risks have increased, but no recession

The buffer that separates the economy from outright recession has been largely exhausted, so a natural question is whether we have seen the worst, or if leading indicators have further to fall. We suspect that the pain for the manufacturing sector is not over, because stock depletion in the current nasty environment necessarily requires scaling back production. Accordingly, the sector’s trend should remain downwardly oriented for some time. Also construction activity is not in good shape, and we don’t expect a recovery anytime soon given that the housing market in several countries has just entered a prolonged slowdown, while commercial real estate should start cooling in line with slower GDP growth. Assessing the outlook for services activity is probably more difficult, but it’s quite safe to affirm that the abrupt decline in most sectors' surveys has gone hand in hand with rising inflation and lower household purchasing power. If this relationship were to also hold in the coming months, some tentative relief could be expected following the sizeable pullback of oil prices seen of late. However, we would expect a normalization of services output at very subdued levels and not a significant turnaround, given that a weakening labor market will keep consumer sentiment subdued even as inflation progressively slows. In a nutshell: the latest business surveys suggest that the risk of recession has increased significantly, but our baseline scenario remains one envisaging very slow, yet positive growth for H2 and well into 2009. Falling oil prices could well be the eurozone’s safety anchor in the coming months.

ECB on hold, next move will be a cut

With growth slowing abruptly and inflation expectations off their peak, risks of a near-term ECB hike have diminished substantially. We have little doubts that current survey numbers are weaker than the central bank had expected when announcing a rate hike in June. They will have to trim their GDP forecast substantially in September, while the inflation outlook will benefit from lower oil prices and could therefore be relatively little changed with respect to three months ago. We expect steady rates for quite some time, and rate cuts starting in mid-2009, when inflation will fall toward 2%.

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Published on  Fri, Aug 1 2008, 13:09 GMT