The “R” word is no longer taboo

We have been pessimistic on the eurozone growth outlook for quite some time, but the intensity of the economic slowdown during the summer has surpassed our expectations. Q2 GDP dipped into negative territory and, probably more worrying, business surveys have continued deteriorating so far in the third quarter, suggesting that underlying growth momentum is now flirting with stagnation. After several months of surprisingly good resilience, it looks like the real economy has eventually capitulated to the lagged effects of tighter financial conditions and the energy shock, with the slowdown involving all demand components and sectors. Manufacturing activity is sinking like a rock and we expect no improvement anytime soon. The new orders-to-stock ratio of the PMI survey holds at a seven-year low, and the OECD leading index, our favorite forward looking indicator to track the industrial cycle, in July hit the lowest level since early 1993, consistent with a 4.0% annualized IP contraction in the third quarter. In this environment, services will dictate whether the eurozone will grow in H2. A technical recession is becoming an increasingly tangible risk.

Our revised forecasts

Taken at face value, our Composite PMI, the European Commission’s ESI and the Eurocoin indicator (all available up to August) deliver a relatively consistent message and point to GDP growth in the neighborhood of 0.1% q-o-q in Q3. We have revised down our GDP forecast accordingly and now expect 0.1% growth in both Q3 and Q4, and a full-year average of 1.3% (from 1.6% previously). Consistent with the sectoral outlook depicted above, risks to our projections remain to the downside. In 2009, we continue to see a modest recovery at a pace which is about half the area’s potential, but the weaker speed of entrance implies that the full year average dips to 0.8% (previous: 1.0%). The ECB’s staff projections are more optimistic as they envisage 1.4% growth for this year and 1.2% for 2009. We remain convinced that a return to around-trend quarterly rates will be a matter of 2010 at the earliest, provided that the exchange rate continues to weaken and the refi rate starts falling next spring, as we predict.

At the single country level, the August plunge in the Ifo expectations component convinced us to pencil in a technical recession in Germany, where we now expect a 0.1% GDP contraction in Q3 and a flat reading in Q4 (yearly average: 1.5% in 2008 and 0.6% in 2009). For France, we forecast 0.9% annualized growth in H2 (which implies 1.1% for 2008 as a whole, and 1.0% for 2009), while in Italy we envisage complete stagnation in the second half of 2008, with rising risks of recession (GDP growth should be up 0.1% this year and 0.3% the next). image002_512_04.png

Consumption: recovery will be sluggish Private consumption has been the main casualty of the recent inflation spike, with spending falling off a cliff in the first half of the year. The crucial question to answer now is how households will react in an environment characterized by easing price pressures, accelerating wage growth, a progressive deterioration in employment dynamics and persistently high shortterm interest rates. Our estimates suggest that employment growth and inflation are the two key variables that drive consumption (obviously with coefficients of opposite sign), while wages and interest rates tend to weigh less in the equation. The fact that wage growth plays a more limited role in consumption developments may seem counterintuitive, but is probably related to the changing composition of disposable income (i.e. the mix of employment/wage growth) at different stages of the business cycle. Recent history suggests that households are more inclined to spend when the increase in disposable income occurs via higher employment rather than higher compensation. In fact, given that job creation lags the business cycle only by a short time (about two quarters), the effect on consumption of strong economic growth coupled with higher employment usually gets amplified by higher household confidence and a lower propensity to save. In contrast, wage dynamics lag the economic cycle by almost two years, and often the peak of earning growth occurs when the economy is already losing steam and job prospects are darkening – with confidence and savings following suit. This is what happened in 2001-2002 and seems to be happening also now. Based mostly on our forecasts for job creation (expected to slow from 1.2% this year to 0.4% in 2009) and inflation (seen declining from 3.6% in 2008 to 2.4% in 2009), assuming that wage growth will keep drifting higher throughout this year before starting to slow in early 2009 and penciling in a declining trend in short-term rates starting from Q1 2009, the projection for y-o-y growth in private consumption hits a trough between Q3 and Q4 2008 and then displays a slight upward trajectory that brings the growth rate at just above 1% at end-2009. In q-o-q terms, after -0.2% in Q2, we see a flat third quarter and a very moderate acceleration thereafter, with growth rates of 0.3% from mid-2009 onwards. While the worst could be over relatively soon, consumption weakness is probably here to stay. We expect household spending to rise 0.4% this year and only 0.7% in 2009, less than the ECB currently envisages (0.7% and 1.1%).

Exports: momentum is fading

The export slowdown has begun, and will probably intensify in coming months as world growth continues to ease and the lagged effect of euro appreciation feeds through – the peak in the TW euro was hit in April, while the currency’s moves tend to have their largest impact on GDP growth after about three quarters. On a two-quarter moving average basis, export growth has slowed from over 6% annualized in Q3 2007 to 2.8 % in Q2 2008. In Q3 2008, the new export order component of the manufacturing PMI has dropped to a five-year low, a level consistent with only 1% annualized export growth.


For Q4 we have penciled in a further loss of momentum, with export dynamics coming virtually to a halt. Things should start to improve – but only very slowly – during the course of next year, after the trough in global growth has been reached and thanks to the support of a weaker currency. On a yearly average basis, exports should be up 3.2% this year and 1.7% in 2009 (the ECB sees 3.7% and 3.5%, respectively).

Investment: the trend is down

The investment outlook is deteriorating. Weaker demand at home and abroad, rising input costs (not only commodities, but also labor costs) and less favorable financing conditions put corporate profitability under pressure – as suggested also by the August ECB Bulletin – and dent business confidence. It’s not surprising then that firms are starting to scale back their investment plans. While we can’t rule out that what we now see is just a soft patch, we do get increasing evidence that seems to validate our “protracted slowdown” story, particularly on the lending front. Net bank loan demand for fixed investment by NFCs – which is a very persistent variable and in the past did a good job in tracking the investment cycle – dropped further in the second quarter, and total lending to NFCs has started its descent, though at 13.2% its growth rate remains quite strong. However, what matters is the trend and, if the historical relationship that envisages household lending (now up only 4.1% y-o-y) leading corporate lending still holds, then lending to NFCs should soften considerably in coming months. On the real economy front, the massive decline in capital good orders from eurozone countries reported by German factories and the clear downward trajectory in our EMU survey based employment indicator strengthen the view that companies are reassessing significantly their investment intentions. In the eurozone, there are no evident signs of over investment in machinery/equipment, which means that capex probably will not fall off a cliff as happened in the 2001-2003 downturn. However, a clear slowdown in business investment coupled with a construction downturn implies that overall investment activity is set for a considerable loss of momentum. As a matter of fact, residential construction is already contracting in France and Spain, while in Italy the yearly growth rate in mortgage lending has turned negative for the first time since the beginning of the series ten years ago. We don’t expect a housing market crash, at least at the area wide level, but after several years of buoyant expansion well in excess of GDP growth, residential construction seems headed for a slowdown that will take several quarters to be digested. If commercial real estate starts easing broadly in line with GDP growth (though with a lag), then infrastructure investment will be the only safety anchor left for the construction sector over the forecast horizon. We expect GFCF to grow 2.1% this year and 0.5% in 2009 (the ECB expects 1.6% and 0.7%).


2 Responses to "The “R” word is no longer taboo"

  1. Guest   September 11, 2008 at 10:10 pm

    The ECB is running out of excuses fast…

  2. Anonymous   September 20, 2008 at 9:37 pm

    Can someone please explain why a 0.1 to a 0.2% contraction means much at all? Shouldn’t all the growth and prosperity of the last few years act as a buffer? I mean 0.2% is so tiny compared to the broader effects we’re seeing. I can understand stocks falling 15-20% if the economy contracted by 10-15% but 0.2%?? America is still GROWING given it’s crisis by 3.3%. So what’s the big deal with a recession anyway? Thanks.