From financial crisis to recession

In the euro zone, after GDP contracted in the second quarter, all business surveys pointed to recession, even before the crisis escalated in mid-September. Activity is likely to contract until mid-2009. GDP will struggle to reach more than 1% this year versus 2.6% in 2007, and will decline by 0.3% in 2009. The PMI manufacturing index, having dropped below 50 (boundary between expansion and contraction) in June, fell to 47.6 in August and then 45 in September. All activity linked components were down sharply, production to 44.1 from 47.6 in August and orders to 41.7 from 44.6. All the main euro zone economies were affected, with Germany down to 47.4 from 49.7 the previous month, France to 43 from 45.8, Italy to 44.4 from 47.1 and Spain to 38.3 from 42.4. The services PMI held up better at 48.4 in September versus 48.5 in August. It was just over 50 in Germany and France (50.2 and 50.1 respectively), just under 50 in Italy (49.4), but was very low in Spain (36.1). The composite PMI, having dropped below 50 (boundary between expansion and contraction) in June, fell to 48.2 in August and then 46.9 in September.

The European Commission’s monthly survey bears out this analysis, with the economic sentiment indicator down 10 points in four months (87.7 in September versus 88.5 in August and 97.6 in May).

This depressed climate is due to the impact of accelerating inflation and, more recently, the deterioration in the labour market on real income and consumer confidence, combined with the downturn in the real estate cycle in several euro zone countries  and the erosion of competitiveness due to the euro’s overvaluation. Residential investment, up 7% in early 2007, is no longer growing, whilst the rise in house prices (3.9% y/y in July) has halved compared with early 2005. Neither trends in mortgage lending (4.3% y/y in July versus 12% in mid-2005) nor the contraction in building permits (down 23.6% y/y this spring) suggest it is going to level off.

As in the USA, the surge in debt has slowed considerably, both in consumer credit (7.1% y/y in December, 4.3% in July) and mortgage lending. Debt will no longer be able to keep demand above the level generated by growth in income, which itself has been affected by a deterioration in the labour market. Growth in employment is expected to drop from 1.8% in 2007 to about 1% this year and will give way to virtual stagnation next year, which will drive unemployment up to 7.7% in 2009 versus 7.3% in 2008. The resulting drop in confidence (balance of -19 in September versus -15 in May) is affecting all euro zone countries (-9 in Germany versus -4 in May, -24 in France versus -18 in May, – 22 in Italy versus -20 in May and -39 in Spain versus -31 in May). This does not augur well for consumption, which is expected to drop towards 0.5% this year versus 1.6% in 2007 (see chart on capital goods purchases).

Business investment supported growth more during the upward part of the cycle in the 2000s than it did in previous cycles. The investment rate (ratio of investment to GDP) was 22% versus a historical average of 20.9%. However, there has been a clear slowdown, with growth in gross fixed investment down from 4.5% at end 2005 to 3% in mid-year. This trend is likely to continue. The manufacturing PMI, a close proxy for capital expenditure, fell to a level compatible with a 1.5% decline in investment. The European Commission survey revealed a decline in equipment needs (with the indicator falling from 15% in 2007 to 7.5%). In addition to the impact of contracting activity, tighter financial conditions have been reflected in a slowdown of growth in lending to non-financial companies, with year-on-year growth falling from 14.9% in March to 13.2% in July according to ECB data. Lastly, trends in profitability (growth in the GDP deflator has fallen below that of unit wage costs, at 2.3% y/y versus 2.4%) reflect an erosion in pricing power and also points to moderation.

Assuming that market rates return to normal, ebbing inflation and a correction of the euro should result in the beginnings of an improvement in the economic climate in the second half of 2009.

Inflation has dropped from 4% in July to 3.8% in August and 3.6% in September, and should continue to lose momentum due to the base for comparison and falling oil prices, but will still remain well above the 2% target rate. In addition, underlying inflation, albeit contained to 1.9%, has accelerated slightly from 1.7% in July due to the emergence of second round effects. The PMI survey input price indicator slipped from 73.8 in July to 63.3 in September, whilst the output price indicator has fallen from 58.1 to 54.9, and the PMI services price indicator has dropped from 54.5 to 51.4, pointing to moderation in inflation. The marked downturn in the labour market argues in favour of moderate pay rises, stemming the recent upward phase (2.9% y/y in the first quarter 2008 versus 2.4% one year earlier). Weaker growth has been accompanied by a decline in productivity gains to 0.8% y/y in the first quarter of 2008 versus 1.4% in the first quarter of 2007, leading to an acceleration in unit wage costs to 2.4% versus just 1% in early 2007. Going forward a few quarters, the adjustment in employment should help moderate these trends. Expectations implied by inflation linked swapsremain relatively high at 2.7%. From a consumer standpoint, they are showing signs of moderation: the expectations indicator for the next twelve months fell to 17 in September (balance taken from the EC monthly survey) versus 22 in August and 30 in July). All in all, inflation should not exceed 2% next year.

Until September, the ECB drew a clear distinction between its interest rate policy and its liquidity policy (its role is to “promote the smooth operating of the payment system), whilst admitting that risks were weighing on activity. It was still quite hawkish in August, stressing the risk of second-round effects. The monetary status quo was expected to be maintained for a few more months, whilst conversely an initial interest rate cut seemed plausible in early 2009. On 2 October, the ECB left its refi rate unchanged at 2%. However, its position has since changed radically; two options – status quo or cut – were discussed during the Council of Governors meeting. The ECB’s assessment of economic activity has lost the optimistic edge prevailing until then: “the most recent data clearly confirms that economic activity in the euro area is weakening”. J-C.Trichet, whilst stressing that inflationary risks had not been eliminated (e.g. German pay rounds covering 3.5 million employees, with IG Metall demanding a rise of 8%), said that risk had ebbed and had opened the door to a future easing: “With the weakening of demand, upside risks to price stability have diminished somewhat”. It is clear that with inflation receding, no change in nominal rates would have driven real rates up, which is clearly not appropriate in a recessionary environment. The need for monetary easing does not stop there, given the current lack of confidence and the resulting spread levels putting pressure on the cost of money. The ECB admits that the financial crisis is having a worse impact on the real economy than it had expected even until recently. However, the ECB has become data and event driven, and developments in the financial crisis led it to cut its refi rate by 50 basis points on 8 October. Monetary easing should continue and the refi rate should be cut to 2.5% by mid-2009 between two Committee meetings, coordinated with other central banks