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Quarterly Outlook: So far, so good — #SaxoStrats
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By Christopher Dembik
For the first time since the 2012 debt crisis, optimism prevails regarding the fate of the euro area. There are strong arguments indicating that economic activity will continue to strengthen.
The euro area is (finally) achieving broad-based growth
Contrary to the US CESI, which is at a two-year low, the euro area economy has remained in positive territory since the fourth quarter of 2016 and economic data have been generally above consensus since the beginning of the year.
After years of high unemployment and slow growth, the euro area is getting back on track. The Eurocoin growth indicator is following an upward trend (plus 0.70%) and many early indicators confirm the positive growth momentum such as the 10-year high in new car registrations and recent consumer surveys. The slowdown in consumer spending in the first quarter of 2017 was a glitch resulting from weak utility spending due to unusually high temperatures.
The run-rate in euro area consumption remains clearly positive in the short and medium terms, probably close to 1.4%-1.5% (year-over-year), helped by growing employment and credit expansion.
Populism has peaked
Political risk was mispriced by the market in the first part of the year. The outcome of the elections in the Netherlands and France, as well as polls in Germany indicating a solid victory for the CDU/CSU (with 41% of voter intentions versus 25% for the SPD and the collapsed AfD holding under 10%) confirm that investors exaggerated political risk.
Populism appears to be in crisis mode all over Europe, as shown by the breakup of the True Finns parliamentary group in Finland and the electoral difficulties faced by the Five Star movement in Italy. Political risk has abated in Europe and has switched to the United States due to the increasing risk of president Trump’s impeachment.
Capital inflows are back
Lower political risk and good economic performance have created a shock of confidence, leading to increasing capital inflows in the euro area. Thus, for the first time in three years, EUR positioning is now back in absolute long territory. Europe’s stock market is also catching up (returns at 15.4% ytd versus 7.1% for the United States).
Investors’ return to European assets is also explained by the fear of a correction in the US market. Currently, the PE versus VIX indicator is at the highest level, sending warning signals to investors and encouraging them to favour markets where shares are cheaper like Europe (and to a lesser extent emerging markets).
Investment is this year’s biggest story
At the global level, investment is recovering from the low point reached in August 2016 when growth stood at less than 1% over one year. The last quarter of 2016 marked a clear reversal of trend and the business surveys now show that the positive momentum should be strengthened.
In the euro area, capital expenditures were strong in Q1’17 and should keep improving in the next six months based on economic expectations. However, a capex renaissance is not yet a done deal since companies are still waiting for further clues about the direction of the global economy. This is in my view the real trigger for higher lasting GDP growth in the euro area.
But the euro area is also facing major headwinds which could derail the economic recovery…
Markets don’t believe central banks can deliver on inflation and wages
The 10-year inflation breakeven for Germany stands at 0.98%; for France it’s 1.05% and for Italy it’s 0.94%. As a matter of fact, inflation and wages are among the most lagging economic indicators in the euro area. The base effect from oil is not helping either due to recent downward pressure on crude prices. In both Q4’16 and Q1’17, wage growth looked much better until the series’ were revised and fell again.
Eurostat wage growth is down to 1.4% y/y in Q1 and the European Central Bank’s gauge is down to 1.25% (the trend lies between 1.4% and 1.5%). Wage growth is expected to remain subdued in the medium term considering that 18% of the euro area’s workforce is underemployed (according to the ECB). The lack of upward pressure on wages considerably complicates the ECB’s mandate, as the bank has over the past few months focused on broad unemployment, job quality and wage growth.
As a consequence, the ECB is quite likely to struggle to make its taper announcement in September. It may be postponed to the end of year, depending on data collection. A postponed tapering could be a welcome sign for market evolution but is also the proof that the euro area economic recovery remains fragile.
Global credit impulse falling
So far in Europe, credit growth remains broadly supportive of economic activity. In terms of stocks, growth in M3 and loans to the private sector have turned positive since 2015, reaching 5.4% and 1.9% respectively (y/y) in Q1’17.
Taking a more detailed view, EU private sector growth has been increasing substantially in core countries, particularly Germany and France (with a strong rebound since mid-2016) but remains negative in many Club Med countries, especially Italy which well deserves its “sick man of the euro area” title.
In terms of flows, the picture is slightly less positive and confirms a slow recovery. In Q1’17, the credit impulse weakened as a result of weaker credit flows and unfavourable base effects. However, this modest setback should be offset in the medium term by very encouraging aggregate demand indicators (especially PMI indicators).
The real question is to how long the euro area will be able to resist to the global credit impulse deceleration. At the core of the slowdown stands China with its increasingly unproductive investments and policy of tightening credit standards to fight against shadow banking. To a lesser extent, Europe is also affected by the economic slowdown in the US (which is ultimately a pretty ordinary step in the economic cycle after eight years of upturn).
If the traditional six-month lag between credit evolution and GDP growth is maintained, it would mean that the global economy, including the euro area, is set for a downturn at some time in the second part of the year.
Of course, this is not an exact science and one can easily imagine a central bank intervention or Chinese fiscal stimulus infusion made in order to avoid this precise scenario. For the euro area, the challenge is to convert the current optimism, linked to lower political risk and the “Macron effect”, into growth gains in order to prevent the end of the US business cycle from shortening the European recovery.
Call me naive but I do believe that “Merkcron” could push for a successful political initiative to relaunch the European project after the German election and by doing so ensure that optimism remains in effect.
German chancellor Merkel will probably not run again in 2022 and, like all politicians, she doubtlessly wants to be remembered for her great achievements… and for now, the list is very short. For his part, Macron is well aware that if he fails to improve the economic situation by the end of his five-year term, the possibility of the National Front coming to power is very high.
There is a genuine convergence of interest between France and Germany’s leaders which could lead to European projects as ambitious as those seen under Giscard and Schmidt.
One such possibility could be the creation of a real budget for the euro area that could serve as stimulus tool when the economy hits bottom.
— Edited by Michael McKenna
Christopher Dembik is head of macro analysis at Saxo Bank