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Friday Notes

Europe in the throes of recession

Fri, Nov 14 2008, 13:14 GMT
by HVB Group Global Markets Research

UniCredit Group  |  View company's profile

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• Contraction. The US and Japan still have to make the call, but it is already official in Europe: The eurozone is in a full-blown recession! After the negative reading in spring, real GDP also receded in the third quarter (pages 4-5 & chart below).

• Recession. The contraction will continue until at least the middle of next year. Leading and sentiment indicators remain in free fall. On average, real GDP throughout the EMU should contract by 0.7% in 2009. Investment and exports should be hit the most, while private consumption could mark marginal growth.

• Reaction. Not even economic policy can now avert the first year of annual GDP contraction since the start of the Monetary Union. The ECB already fell behind the curve with its hesitant stance; even at a refi rate of 2%, short-term real interest rates will remain in positive territory next year. And fiscal programs, first and foremost the German one, have no real bite (pages 6-8).

• History. Together with the contraction in Japan, the United Kingdom and the US, where consumption is falling at an ever faster pace (pages 9-11), the industrialized world is sliding into a recession that will be even more pronounced than the last one in 1982.

• Further topics:

  – Weekly Comment: Gloomier and gloomier (page 2).

  – US: Paulson shifts course (page 12).

  – Data outlook: EMU purchasing managers increasingly bearish; US prices to decline substantially (page 14).

  – Market outlook: Government bonds in calmer waters again; EUR still under pressure (page 21).

Gloomier and gloomier

The risks have materialized, as Trichet would say, and the eurozone has stumbled into a recession. The drastic deterioration in activity indicators that had emerged a couple of months ago has continued and gathered momentum, while the external environment has worsened further. The pace of the deterioration has been so fast that the IMF, which was already ahead of the curve, has been forced to downgrade the forecasts it had published barely a month ago in the World Economic Outlook. The IMF now sees the developed economies in recession next year and the emerging economies growing at a relatively weak 5% pace, resulting in a global growth rate of just above 2%, down from a previous forecast of 3%.

Our own forecasts are similar. Following the most recent data, we now expect both the US and the eurozone to be in recession for the full year 2009, with US GDP contracting by 0.4% in real terms for the year as a whole, and eurozone GDP contracting by 0.7%. So not only has the economic fallout been more severe than expected, but, as we feared and predicted, the eurozone has not been immune. Most worryingly, this ongoing deterioration in economic activity has materialized while the corporate sector in Europe still enjoyed ample access to credit, as the ECB has emphasized over the last fifteen months. In other words, these forecasts are still exposed to the risk of a credit crunch which keeps hanging like a Damocles' Sword over the eurozone’s growth prospects. How serious is the risk of a credit crunch? Serious enough to consider, in our view. On the one hand, the ongoing efforts of the ECB and of national governments to support the national banking systems have dissipated the concern of a systemic meltdown of the European (and global) financial system, and should hopefully enable a gradual normalization of money and interbank markets in the coming months. On the other hand, however, European banks are being pushed by markets to pursue higher and higher Tier 1 capital ratios, and will face a challenging funding situation in the year ahead—two factors that argue against the generous credit extension that the economic downturn would instead require.

A further risk that the eurozone faces is posed by the concomitant deterioration in the outlook for Central and Eastern Europe. Part of this risk is a sort of “echo” effect: the slowing growth in the eurozone dampens CEE economic activity, in turn acting as a drag on the eurozone. Part of it though is a more specific CEE risk, arising from financing difficulties triggered by the global deleveraging and the attendant drying up of capital flows to CEE. The eurozone and CEE are by now joined at the hip, as the extent of economic and financial linkages is such that turmoil in one part of the region necessarily carries serious repercussion for the other. Eurozone policymakers are well aware of this, and have therefore already been active in supporting rescue measures for those CEE countries that have found themselves first in the line of fire, such as Hungary and Ukraine.

As the IMF also pointed out, this gloomy global scenario and the attached risks call for a decisive further policy response. The ECB has already cut its refi rate by 100 bp, including the 50 bp delivered as part of the joint emergency cut with the Fed and other major central banks. We expect it will reduce the refi by a further 50 bp in December and that it will lower it all the way to 2.0% within the first half of next year. We also see the risk it could push the rate even lower, as the present crisis is more severe than the one that triggered the previous descent to 2.0%, and as inflation is set to plummet by the middle of next year. Fiscal policy should also do its part. We expect that several eurozone countries will breach the 3.0% deficit ceiling next year in order to support growth. We do not, however, see this as a permanent abandonment of the Stability and Growth Pact. Rather, we believe countries will signal clearly that, while exceptional circumstances justify a temporary departure from the statutory ceilings, governments remain in control of the path that will bring deficits back within target. It is very important that this signal be given in as coordinated a way as possible. Different countries are approaching this difficult juncture in different positions, and unfortunately those countries which need the fiscal expansion most can afford it the least. Countries with larger public debts are already being punished more by the markets, as we have seen by the widening in yield spreads between peripheral and core countries. If their fiscal positions were to weaken more significantly than others, they might face a punishing further rise in the cost of debt servicing.

The significant further rate cuts that we expect from the ECB should open the way for an important reduction in money market rates, with a decline in 3M Euribor rates of some 200 bp from current levels, i.e. reaching about 2½ % by the middle of next year. This should be accompanied by a moderate steepening of the euro yield curve, driven first by a significant decline at the short end, and later by a recovery in long-end yields in the expectation of a recovery in growth and pulled by a similar movement in the US. Meanwhile, we expect the EUR to remain under pressure against the USD in the short term, reflecting the relentless stream of bad economic news emanating from the euro area.

The upcoming G-20 meeting has become the focus of hopes and in some cases unrealistic expectations. This is understandable for several reasons: the extreme severity of the crisis cries out for more serious policy responses; there is a focus on international coordination; and some policymakers have talked about the need for a revamping of the global financial system similar in scope and ambition to the Bretton Woods agreement. We do not believe, however, that conditions are right for anything even remotely approaching the Bretton Woods experience. There will be emphasis on the need for joint, or at least similar measures to support global growth. There will be a reiteration of the commitment to reforming and strengthening the global financial architecture – but this is now an ongoing medium-term project. But there will not be a fundamental reform of the financial system. Nor should we expect a sudden reform of global exchange rate regimes. While FX movements have attracted enormous attention, it is important to keep in mind that recently they have mostly been in line with fundamentals: the strengthening of the JPY, the weakening of the GBP and EUR, are in line with what fundamentals would suggest, and it is therefore extremely unlikely that we will see a consensus to oppose them. Japan will understandably grow increasingly uncomfortable with further yen appreciation, and unilateral intervention will eventually become likely. But no coordinated intervention seems in the cards now or for the foreseeable future.

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Published on  Fri, Nov 14 2008, 13:23 GMT

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