“Did we miss something?” Pros and Cons for a sustainable and strong eurozone recovery after 3Q 2009. Euro Thoughts October 19 -23 2009

The good news of last week was, as we flagged, the rebound in August industrial production with large upward revisions to previous data, while the not-so-good news was the first signs that investors’ sentiment, as measured by the ZEW index, is leveling off. Key figures of this week will be the flash release of October PMIs, and the Germany’s Ifo index for the same month (both on Fri 23) that should post moderate increases, thus adding further evidence to the incipient recovery. However, apart from the manufacturing PMI’s return into positive growth territory after more than one year, leading components of these business surveys should show some fatigue after the summer’s strong rebound.

Last week ended with some relatively dovish remarks by ECB’s Bini Smaghi who, speaking about the financial crisis in Florence on Oct 16 (http://www.ecb.int/press/key/date/2009/html/sp091016_2.en.html), stroke a very cautious note on the lending cycle by claiming that “…in the euro area, there is evidence that the credit quality of banks’ loan books has deteriorated on account of intensifying financial distress in the household and corporate sectors. Banks could be getting over the valuation losses they have suffered on their securities holdings; however, the rapid increase in loan loss provisions suggests that a renewed wave of write-downs on euro area banks’ assets may be imminent, with ensuing capital reductions”. Speaking near Florence two days after, he added that loan growth is likely to resume positive growth only in 2010. Egoistically, we feel relieved by such remarks because it is undisputable that over the recent weeks the markets’ mood and, to a certain extent, hard economic evidence have decisively turned for the better, challenging our cautious outlook as it has never been in the last eighteen months.

Some positives do exist but are they strong enough?

“Are we wrong?”. This question keeps popping in my mind after we revised up (to 0.4% qoq) our 3Q GDP call. Plus, after the Bank of Italy’s revision to 1% of Italy’s third quarter GDP forecast, risks are probably tilted to the upside. Clouds on the horizon (strong euro, restrained credit, higher unemployment) keep lingering. Within this framework, the ECB is still forecasting a very meager 0.2% GDP growth next year. Although it is easy to guess that this number will be lifted in the next round of forecasts in December, recent rhetoric by ECB officials suggests that it is unlikely that the central bank will be carried away by this mounting optimism. Being in ECB’s company is somewhat reassuring on our ability of forecasters. At the end of 2005, the central bank decided to embark on a tightening cycle on the basis of a bullish outlook if compared with the consensus of the time. Unfolding of the events proved they were right, and markets were wrong. History repeating would prevent us from materially changing our GDP forecasts set. However, it is worth looking at positive signals in order to detect their strength and their ability to challenge our outlook.

1. The first and most important factor that may point to a stronger-than expected recovery is the policy support. Although fiscal policy has been somewhat shier than in the Anglo-Saxon world, monetary policy response has been swift (after Lehman), and aggressive. In terms of core inflation, the real refi rate is marginally negative; the bulk of credit easing measures has eased dramatically conditions in money markets and helped the financial sector. Although the credit channel of monetary policy has been severely impaired and the easing pass-through on lending rates has been only partial, nonetheless the monetary environment is very accommodative. Considering the usual lag with which monetary policy usually works and allowing for a more delayed response because of the impaired financial sector, we are exactly at the beginning of the period where the impact on the real economy of a supportive monetary stance becomes more visible. Such an impact is about to gather momentum in next months.

2. The immediate result of what has been described above is the ongoing easing in aggregate financial conditions. True, a divergence between monetary and financial conditions is currently at play. In fact, the Monetary Conditions Index (MCI) has stopped easing over the past year (and has eventually tightened over the past quarter) on the back of a stronger euro offsetting lower money market rates. However, on the other hand, the broader Financial Conditions Index (FCI) keeps easing thanks to lower yields, narrower credit spreads, and rallying equity markets.

MCI and FCI – a disconnection



Source: Bloomberg, ECB, UniCredit Research

Furthermore, real M1 growth (a medium to long-term proxy for money demand for transactions) is past its turning point and is experiencing a stellar recovery. Besides all the distortions due to liquidity interventions by the ECB, it is a fact that – according to past correlations – narrow money supply points to robust GDP growth in mid-2010.


REAL M1 – nice rebound 


Source: ECB, Eurostat, UniCredit Research

3. The mood in financial markets remains very upbeat. Historically, discrete shifts in financial markets’ sentiment have heralded turning points in the real business cycle. This time may be of no exception with the addition that by last March the deterioration in both sentiment and real economic performance had been so pronounced that the rebound couldn’t have been less pronounced than what we have witnessed so far. By the middle of the second quarter, it was clear that a positive loop between equities and growth was in force. Not only the upturn in markets was reflecting a better outlook, but also current GDP performance was benefiting from strong equities. More in general, business expectations are pointing to a nice recovery in 2010, not the somewhat muted upturn the ECB and we are expecting. Ifo Business expectations have risen massively from their bottom of 77.0 in December 2008 to the current 95.7. Undoubtedly, this level is consistent with a sustainable growth after the 3Q rebound.

4. After the dramatic fallout of last winter, the manufacturing sector has finally turned and is currently recovering strongly. Industrial new orders are past their turning point thanks to the two consecutive increases posted in June and July 2009 (4.1 and 2.0% mom, respectively), and are now signaling that the recession is definitely over. If orders maintain this momentum in next months, then the 3Q rebound would find more ground.

These are the main reasons that may induce to think that the eurozone recovery will prove stronger than what we (and the ECB) currently envisage. The boulders that stand against this rosier scenario and that underpin our still-cautious outlook are (in a nutshell):

1.     Weak labor market conditions, threatening the private consumption outlook together with an adverse real income dynamics.

2.     Firms’ capacity utilization at its historical low which prevents from sketching a strong capex acceleration.

3.     Loan growth to non-financials bound to remain scant (when not negative) for some more months. Another heavy drag on investments.

4.     A strong euro, that risks putting an unwelcome cap to export growth, now enjoying the recovery in global trade.

On top of these reasons, there is the evidence that recessions induced by financial crises are hard to digest and following recoveries are usually very timid, as financial dislocations and the banking sector licking its wounds impede a strong rebound. Reinhart and Rogoff in a couple of recent seminal works (http://www.economics.harvard.edu/files/faculty/51_This_Time_Is_Different.pdf, and http://www.economics.harvard.edu/files/faculty/51_Aftermath.pdf) clearly explain why that is the case and underpin our worries. It is true that, compared to the historical episodes they survey, the policy response in the aftermath of the Lehman collapse has been different and much stronger. But, for the time being, this is enough only to claim that 3Q growth was not a dead-cat bounce. Hardly a takeoff for a nice flight…