October 2008 represented the high point of the ongoing financial crisis. In Trichet’s words after the Lehman collapse, we entered a new era and financial strains have become almost unbearable. The toll on economic activity will be huge and, as we have been arguing for a while, the banking system is at the center of the crisis. Lending standards have been tightened significantly in response to deleveraging efforts, increasingly expensive bank capital, and almost-frozen access to wholesale funding. At face value, lending to firms continues to grow at a nice pace, but the combined effect of plunging financial equities, skyrocketing real corporate bond yields and qualitative evidence from the ECB Bank Lending Survey will result in a sizeable reduction in the credit flow to the economy. Fiscal policy measures aimed at preventing the seizure of the credit channel will help, but a credit rationing can hardly be avoided. Fixed investment will be severely impacted and, concurrently, the global economy is deteriorating fast, with emerging countries –Eastern Europe in particular – joining the widespread slowdown. As a consequence, we are revising down our 2009 GDP forecast to -0.7% from the prior +0.3%. Below, we provide arguments for our change of call.
Supply hampered by industrial recession
The industrial recession is set to intensify further. The manufacturing sector is in deep trouble and, unfortunately, the tumble in the factory PMI to an all-time low is not the only alarming news. What is truly worrying is the huge drop in new orders relative to stocks as reported by the PMI survey: with new orders down to a series-low of 36.2 and stocks up to a serieshigh of 51.3, the new orders-stock ratio in October collapsed 3.5 st. dev. below its long-term average. We have long argued that the manufacturing contraction was going to worsen through year-end, but this is a bad surprise also for our already pessimistic outlook. Chart 1 shows the residual of the regression of the headline manufacturing PMI on the new ordersstock ratio, which provides an intuitive gauge of how activity (mostly production, but also employment) has adjusted to the current environment of slowing orders and rising inventories. The still positive residual indicates that the steep fall in production seen so far has not been sufficient to counter the decline in orders, and therefore unwanted inventories are still being accumulated. As can be seen from the chart, past episodes of substantial inventory overhang (i.e. when residuals have gone through the +1 st. dev. band) have led firms to slash activity to levels well below “equilibrium” – i.e. residual have tended to undershoot – before the manufacturing cycle can accelerate anew. This makes a further slump in production (and employment) likely in the coming months even if stocks and orders were to start normalizing. Add to this the fact that the OECD leading index – our favorite indicator to spot turning points in the factory cycle – continues to plummet: in September, it was down to a 16-year low.
Given that in the past services activity has hardly decoupled from developments in manufacturing, overall growth momentum seems set to deteriorate further from current already recessionary levels. After a likely 0.1% GDP contraction in Q3, the pace of recession should deepen in Q4 2008 and Q1 2009 – we have penciled in -0.4% for both quarters – and negative growth will probably continue in Q2 2009. Only in H2 2009 we should be able to see a resumption of marginally positive growth rates.
Investments and net exports will drag down aggregate demand
On the demand side, the bulk of our revision concerns capex and exports. The full impact of the credit rationing (let’s try not to speak about crunch, at least for now) remains hard to gauge, but the extent of the most recent drop in sentiment indicators – and the perception that things will need to get worse before they get better – is per se a good enough reason to scale back significantly our forecasts for business investment. We run regressions of the yearly growth rate of capex (machinery plus means of transport plus other) on several eurozone business surveys, and found that the assessment of recent demand in the service sector as reported by the EC survey delivers the best fit. This indicator suggests that business investment at the beginning of Q4 is already on a steep downward trend. The same idea is conveyed by the third decline in a row in loan demand for fixed investment as reported by banks polled for the November Bank Lending Survey. Loan demand is a reliable indicator of the investment cycle, and its contraction is now well entrenched, with further declines likely given the darkened economic mood and tighter lending standards.
Clearly, almost everywhere in the euro area fiscal authorities are supporting banks to prevent an outright credit crunch and guarantee a sound financing of companies and households. Our view is that the (welcome) fiscal measures won’t be able to offset completely the several strains banks have now to deal with on their liabilities side. The cost of equity and bond capital has risen massively since September in the wake of plunging equities and widening spreads. Interbank money markets remain jittery and the ECB cuts have so far helped only partially, at a time when a physiological slowdown for business investment was already in the cards after the strong performance of 2006-2007. While we previously thought that the capex correction in this cycle would have turned out to be milder than in the 2001-2002 downturn because of the lack of overinvestment, these hopes now seem misplaced. From peak to trough, we expect yearly capex growth to fall from 8.6% in mid-2006 to -6.5% in mid-2009: this compares with a drop from around 11% in Q3 1998 to a low of about -4% in early 2002. As a result, we see Gross Fixed Capital Formation (GFCF) shrinking 3.5% next year, with capex plunging 5.7% and construction investment declining 1.3%. The quarterly negative growth profile for investment is bound to last until the beginning of 2010.
In 2009, net exports will subtract 0.7pp from overall growth, due to an outright contraction in both exports (-2.3%) and imports (-0.8%). The export orders component in the PMI is signaling an export contraction of about 8% annualized at the beginning of the last quarter of 2008. So far, among the eurozone commercial partners, the slowdown in the US and UK is taking the heavier toll on export performance. However, in the next months, the abrupt deterioration in the Eastern Europe outlook is likely to put further pressure on manufacturers and contribute to push export growth deeply into contraction territory. Some key large countries in Eastern Europe will benefit from plans undertaken by the IMF, the EU and other international bodies but, as argued before for corporate lending, this won’t prevent a fallout in growth rates, mainly driven by private consumption that will likely suffer from the diffuse indexation of mortgages to foreign currencies.
Next year, the only (scant) positive contribution to GDP will come from private consumption. The squeeze induced by spiking commodity inflation and a eurozone-style rise in precautionary savings at the burst of the financial turmoil prevented private consumption from accelerating since the third quarter of 2007. Private outlays have in fact entered a technical recession in H1 2008. The projected steep decline in headline inflation and the late-cycle acceleration in nominal wages will provide some relief in the next few quarters, but this will only succeed in keeping household spending growth only marginally above the zero line. The unemployment rate will be on the rise sharply once the German labor market turns, employment growth will turn negative for most of 2009 and the wage drift component will suffer from the ongoing recession, so the aggregate sum of wages will grow modestly. Household consumption will grow only 0.1% in 2009, delivering one decimal of contribution to overall GDP.