For the first time since the inception of the common currency area, eurozone GDP contracted by 0.2% q-o-q in the second quarter of 2008. The country breakdown has been slightly surprising with Germany faring a bit better than feared (-0.5% q-o-q), and France and Italy both contracting by 0.3%. France is the real negative surprise of the day. The demand breakdown – that will be published on September 3 – risks being as disappointing as the overall GDP figure. We assume that private consumption was flattish, mainly because of an adverse real income dynamics induced by the then-spiking oil prices and by a more difficult access to credit for households. Gross fixed capital formation probably shrank (-0.5% q-o-q our assumption) because of the construction setback from the strong Q1, but also because of a subdued capex dynamics. Export growth slowed substantially, hurt by the strong currency and softening global demand, and so did imports reflecting the weakness in domestic demand. As a result, net export should have dragged 0.2pp from overall growth.
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. 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: 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 In July 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.
Contemporarily, there was good news on the inflation front. July’s CPI was revised down to 4.0% mostly thanks to aggressive sales on clothing. Here the good news is that given the recent drop in oil prices, the peak should be behind us. Also in line with our view was the decline in core inflation to 1.7% from the prior 1.8%. Another signal that the growth slowdown is taking care of the underlying fundamental inflation.
ECB bottom line. With growth slowing abruptly and inflation expectations off their peak, risks of a near-term ECB hike have been wiped out. 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. So far markets have shown a dovish interpretation of the last ECB meeting and empirical evidence, with bonds rallying and the EUR-USD falling off a cliff. We would be a bit more cautious. Almost at the end of last week’s press conference, when commenting the movement in inflation expectations – that we would ascribe more to the oil dynamic than to the ECB July move – Trichet said that there will be no complacency on inflationary pressures. And clearly, the central bank is not pleased at all with the curve already pricing in rate cuts next year. Plus the Q3 Survey of Professional Forecasters (out this morning) shows inflation expectations for 2010 at 2.1% and the long-term forecasts at 2%, hence both above the ECB’s definition of price stability. In the ECB’s mind, the process should be more gradual, but they are paying the price of the communication mistake of the June meeting and seem having trouble in steering effectively market expectations as they did in the past. Hence, we remain convinced that rate hikes for this year are now extremely unlikely but before seeing some relaxation in the stance it will take some time, no earlier than the first half of next year.
We expect steady rates for quite some time, and rate cuts starting in mid-2009, when inflation will fall toward 2%.