Is the Eurozone Heading Off a Cliff?

One need not be well versed in the art of reading entrails or posses any other kind of unworldly powers to see that the Eurozone economy may be about to head off over the cliff. Now, just as the Q1 GDP figure was something of a technical glitch due to the forward pushing of investment which made Germany ride an impressive 1.5% reading q-o-q, so is the corresponding Q2 figure likely to be a similar (negative) glitch. The only important question is the extent of the slowdown, since without that we really cannot build any sound forecasts for an annual growth rate of the Eurozone, not to speak of Germany itself.Over

Yet, we move beyond the immediate excitement of the upcoming GDP release and the extent to which it will have vultures gathering over an increasingly weak economy, the forward looking indicators also turned an abysmal showing. Consider then the following: In Italy, business confidence slumped to the lowest level in seven years; in France, it clocked in at the lowest since 2005 and in Germany the ever so important [for ECB policy, that is] IFO survey declined to a three year low.

But the show does not, by any means of the phrase, stop here. Adding to the gloom we also got the PMI release today showing its lowest reading since 2001.

Furthermore, in Spain where it isn't the proverbial Rome but moreso Madrid (or perhaps the Cedulas?) that is burning, an already groggy economy got some additional blows in the kidneys (see also below) as we learned how secondary inflation rose to an all time highs at one and the same time as the economy shed jobs in Q2 to move into double digit territory with respect to the unemployment rate. As for real economic data consumer spending in France added a near final nail to the coffin by dropping 0.4%. Furthermore, data released on French builders also confirmed that slowdown as the index slid two points. Builders noted in particular how order books were judged to be less vibrant than normal as well as they see a slowdown in activity for the next three months.

There can be little doubt that the data releases above are suggestive of the fact that the Eurozone may well be heading for a full blown recession in Q2 and Q3. In that light, Trichet also moved in lately, and with good reason, to reassure us that while the next two quarters would see a "trough" in economic growth we would revert to normal services from Q4 and onwards.

Two important questions arise then.

First of all we have the obvious question of just how far the this slowdown will drag on, and as a derivative, what kind of trend will we revert to? As I have stated above it is really difficult to say anything remotely sane about GDP outlook until we get Q2 numbers (currently the Eurozone is standing at a 2.8% annualised q-o-q with Germany at 6% annualised q-o-q (!), and I am sure not even the greatest optimist would venture such a call). However, for me the question about the "trend" or "normal" pace of growth is much more interesting since my feeling is that the underlying momentum of a post recession Eurozone will surprise on the negative side. As such, it is not about the potential recession itself since these things come and go (although with a bit too high frequency in some countries it seems) but much more so, it is a question about the Eurozone which emerges and what we can reasonably expect in terms of overall gusto.

A Step too Far?

Amidst all this doom and gloom and recession saber rattling some would perhaps feel inclined to point out that the ECB seems to be getting just what it ordered with its recent 0.25% rate increase as oil prices have dropped smartly in the past weeks. I can see this point, if anyone should feel like making it, but I am also sure that we can all agree that oil prices these days are moved by more than the ECB. In fact, a raising ECB in so far as it would pummel the USD should not make oil go anywhere but up.

Meanwhile, the governing council at the ECB must obviously be watching the incoming barrage of poor data with more than a faint eye since it comes just weeks after rates were increased. Now, I should make it clear that this was the ECB's intention all along. Ever since the crisis began it was obvious for everybody that it would push the business cycle into reverse but the ECB always opted for inflation over growth; or at least it did not succumb to the temptation to lower rates. Now the butcher is coming to collect his bill and it could seem as if the ECB's credit card is in for a nasty overdraft. Actually, this may turn out to be a quite literal conceptualization if the Spanish mortgage market is about to turn into a pile of smoldering bricks.

To sum up, Q2 GDP will be interesting to watch since it will give us a sense of overall direction. Other than that I am watching Germany very closely, and most specifically the export link with Eastern Europe. Basically, Germany has been living on exports not only to its main trading partners in the Eurozone (who are all now slowing considerably) but also on the margin to the CEE economies. Especially this last link is about to break now, and the repercussions will be swift and severe in terms of economic momentum lost. Finally, one cannot help but feel that Spain may be in for the worst of all (perhaps even worse than Italy). The link between builders and their banks seems a crucial issue to watch going forward.

Want More?

Below you will find a list of statistical reports used in this piece as well as other reports. This is for the analysts and investors who want the gory details.

France Business Survev (INSEE) - Enquête mensuelle de conjoncture dans l’industrie – Juillet 2008

France Business Survev (INSEE) - Enquête mensuelle de conjoncture dans le commerce de détail et le commerce
et la réparation automobile – Juillet 2008

France Consumer Spending (INSEE) - Dépenses de consommation des ménages en produits manufacturés - Juin 2008

France Building Activity Survey (INSEE) - Enquête mensuelle de conjoncture dans le bâtiment - Juillet 2008

Germany - IFO Survey, July 2008

Spain (INE) - Industry New Orders Received Indices and Industry Turnover Indices, May 2008

Spain (INE) - Industrial Price Indices, June 2008

Spain (INE) - Services Sector Activity Indicators, May 2008

Comments

[NLFEnergy:]

Economic growth won't occur in Europe due to the continued implementation of socialist policies.

2008 Jul 25 11:16 AM

[junkyarddog:]

Very interesting observations. I wonder if the author (Claus) feels all of this spells the end of the Euro.

Can Spain / Italy / France cope with a strong(er) Euro?

2008 Jul 25 12:17 PM

[User 232593:]

well,we now have socialism here.you can call it conservative socialism. i never thought i would see this under a republican administration.i guess to save the big guys anything goes.what a joke.they must be laughing in europe.

2008 Jul 25 12:22 PM

[JoeG:]

I can't read his article as his sentence structure is filled with so many run on sentences that the point of what his is trying to say is greatly diluted by the lack of commas (breath) which make a complex subject that is the economic future of the Eurozone more difficult to understand (sigh) than need be when a comma period or sentence break would strengthen his position and guide the reader in this case me instead lining the dialog with misplaced modifiers.

2008 Jul 25 01:16 PM

[John Pseudonym:]

English is probably not his first language...

Back off JoeG!

2008 Jul 25 01:47 PM

[bypass:]

I concur with John. Well written article for a second language.

2008 Jul 25 02:20 PM

[Kunst:]

The first rule of clear writing: Keep it short -- words, sentences, the article itself. Use periods. The essence of good writing is editing: eliminate all but the essential.

2008 Jul 25 04:33 PM

[bbzz24:]

With a recession or not, it seems only the builders in the structurally weak Spain will suffer. Unemployment in rest of Europe will not be much of a problem to the unemployed who will be getting 80% of their last check's pay for about 2 years after laid off.

But economic growth has different drivers on both sides of the Atlantic and this does not seem fully appreciated. In Europe it is more organic: with real production driving GDP, and deficits about the GDP growth level. In the USA it is monetary: the government is printing too much money and some of it actually contributes to this GDP growth. Consider this: budget deficit spending is 2x the annual GDP growth for quite some time!!! How is this possible? Well, the Chinese and Japanese are willing, so far, to fund the U.S. growth in exchange for future claims against the government and the U.S. taxpayer.

In Europe much of gov't spending is on social programs: it helps with consumption but does not as directly affect GDP as imports soak up much of it. In the U.S. gov't spending is mostly in the military area which is entirely domestic and thus has almost 1:1 effect on GDP growth.

Claus, don't bother about the comments on your English: your sentences are difficult to read only for Americans, and that has much more to do with their educational background than your English.

2008 Jul 26 02:19 AM

[Claus Vistesen:]

Thanks for comments guys ... also the ones on my english language skills; and yep, English is my second language (I really mean this). I appreciate JoeG's comments since all I can do is move forward and learn with each piece that I write. At the end of the day, I don't want my sentences to be difficultly read. Oh and to bbzz24 ... thanks for your related comment too; it assures me that I am not completely off the chart.

Anyways ... on to the business at hand.

First of all there is the comment made by Junky about the potential demise of the Euro. I don't see it like this at all. I think it is quite far fetched to speak of a Eurozone break-up at this point since the costs would be too great (after all). That does not mean however that there won't be challenges. For me, Italy is the biggest "if" since at some point in the future they will possibly have to default on their debt. I am not sure what the ECB would/could do in such a situation? One could also imagine some kind of knee jerk Italian ultimatum with respect to the Euro system; especially in light of the fact that Berlusconi is at the rudder.

Another point would be if e.g. Spain, or perhaps the aforementioned Italy falls into a very severe deflationary recession on the back of the current mess. It would be very difficult for the ECB to accomodate such a scenario I think. Of course, some kind of EU transfer in kind might be a possibility here. But where does this leave us with the whole convergence and one-size-fits all monetary policy hypothesis? Ultimately, the ECB may be facing a credibility backlash as a result of the current myopic focus on inflation.

@Bbzz24

I completely agree with the main thrust of your argument. It makes little sense to invoke this US v. Europe football match since these are two different regions/economic structures. However, in this light specifically it also worries me to hear Trichet speaking, at one of the press conferences, about how the ECB is like the Fed, in that it presides over one homogenous economy. This is BS (!) and acting accordingly will only bring tears I think.

"Consider this: budget deficit spending is 2x the annual GDP growth for quite some time!!! How is this possible? Well, the Chinese and Japanese are willing, so far, to fund the U.S. growth in exchange for future claims against the government and the U.S. taxpayer."

Quite, this system is obviously unsustainable in its current form and with the velocity it is growing. However, my guess is that this is structural in the sense that e.g. Japan cannot
do anything else than hope to live off of claims on more "vibrant" (read: young) economies. Yet, this does not mean that emerging market mercantilism and the subsequent US overconsumption won't come to an end. My guess is that the system is crumbling as I type since the US is well under way to transform into a different economy. I won't be easy and it won't be painless but it will happen ... gasoline tax anybody :)?

Cheers

Claus

2008 Jul 26 04:13 AM

[CLH:]

Good post Claus. The end result is that the dollar will continue to strengthen. This is good news for bringing down the price of commodities and the need to raise interest rates is lessened.

2008 Jul 26 07:16 AM

[bbzz24:]

Claus thanks for the follow up.
I am getting the same feeling about the U.S. economy. Taxes are about 10-15% lower than in Europe but there are no social benefits and against the very little already promised the government has borrowed and spent already big time.
Add to this the huge urban sprawls and lack of any desire among kids to study sciences, the huge external debts....
It looks there will be quite a bit of rebalancing in the world.

2008 Jul 26 02:44 PM