Europe’s impossible recovery

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The positive stream of eurozone economic data has continued, supporting our view that the economy will surprise the gloomy consensus positively this year.

The eurozone economy looks set for a firmer upswing than expected by the gloomy consensus Nick Kounis Nick Kounis Head of Macro Research

Meanwhile, Greece’s reform plan was approved by the Eurogroup, but this should be seen as the starting point for negotiations rather than the end of them. The ECB meets this week and will likely begin bond purchases shortly after. In the US, Fed Chair Yellen paved the way for a rate hike later this year, while core inflation data also confirmed this prospect. Global activity data have been encouraging, signalling firmer growth in industry and trade.

The recovery they said would not happen

It was not so long ago that putting the words ‘eurozone’ and ‘recovery’ in the same sentence would trigger looks of surprise. Larry Summers, former US Treasury Secretary and one of the world’s top economists, noted earlier in the year that the eurozone was on the brink of a ‘deflationary spiral’ that would last for a ‘decade’, and that QE would be ‘insufficient’. In addition, the IMF saw the risks of a prolonged recession in the eurozone at 35-40% in October of last year. A convincing recovery looked unlikely to many.

Positive eurozone data flow has continued

Yet over the last few weeks evidence has mounted that eurozone economy is starting to gain some momentum. This trend has continued over recent days. The European Commission’s economic sentiment indicator rose to 102.1 in February, from 101.4 in January. Economic sentiment even rose in Greece, providing some early signs that confidence is stabilising, as prospects for a deal improved.

Meanwhile, underlying credit growth to the private sector rose to 0.5% yoy in January from 0.2% yoy in December. This is in line with evidence from the ECB’s Bank Lending Survey, which reported that banks are easing lending standards, while loan demand is also rising. These trends are also visible in money supply data. M1 money supply – a good leading indicator for the cycle – rose by 9% yoy from 7.9% yoy the month before.

Finally, inflation rates became significantly less negative in February according to data from Germany, Spain and Italy. This supports the idea that negative inflation is a relatively transient phenomenon driven by the collapse in oil prices, rather than bad deflation reflecting recessionary forces. The estimate for eurozone inflation next week will probably show it rising to -0.2 or -0.3% yoy from -0.6% yoy in January.

Overall, the eurozone economy looks set for a firmer upswing than expected by the gloomy consensus. That does not mean it will be spectacular, but it will be a sustained recovery.

Europe's impossibe recovery graph 1

Greece takes another step forward

After last week’s Eurogroup deal on Greece, the country delivered a list of structural reforms on Monday. The Eurogroup approved the list, but this is far from the end of the process. Indeed, the list of reforms is seen as a ‘starting point’ for a successful conclusion of the review under the current arrangement. This review should be completed by the end of April. Only once this is done, Greece will receive EUR 1.8bn from the EFSF and a similar amount from the ECB’s SMP profits on Greek government bonds.

This agreement has two important implications. First of all, potentially difficult negotiations between Greece and the Eurogroup/institutions lie ahead. Second of all, until Greece has completed to review, its challenges in terms of liquidity remain. EU officials hope that this issue will be solved by a quick completion of the review.

ECB QE set to start soon

The ECB will likely publish more details about its extended large scale asset purchase programme following next week’s meeting. Actual purchases could follow soon after the publication of this legal framework, with Friday or the following Monday as the main possibilities. With QE approaching eurozone government bond yields declined, led by the periphery, while the euro weakened over the last few days. We think these trends will continue over the next few months.

Indeed, German – and other core government – bond yields will probably be pushed down further. The ECB’s programme will create a scarcity of AAA government bonds and the central bank will likely need to pay high prices to meet its targets. In addition, search for yield, will lead to ongoing outperformance of other member states’ government bonds (especially the periphery) compared to Germany.

Finally, the euro will continue to fall against the dollar, reflecting the chasm opening up between the respective monetary policy stance of the ECB and the Fed.

Europe's impossibe recovery graph 2

Fed Chair Yellen paves the way for higher rates

Indeed, Fed Chair Yellen set the scene for the start of interest rate increases later this year in her semi-annual testimony to Congress. She sounded relatively upbeat on the outlook, while admitting that some challenges remained. Ms. Yellen said that ‘considerable progress has been achieved in the recovery of the labour market, though room for further improvement remains’. At the same time, economic growth had been increasing at a ‘solid rate’. Although inflation has been low, the Committee expected it to rise gradually towards 2%. Against this background, she said that ‘If economic conditions continue to improve…the Committee will at some point begin considering an increase in the target range for the federal funds rate on a meeting-by-meeting basis’. Before then, the Fed would likely drop the ‘patient’ phrase from its forward guidance, though that would not mean a rate hike would mechanically follow in two meetings.

Our base case remains that the Fed will raise interest rates for the first time in June. However, there is a chance that it will wait somewhat longer. Core inflation stabilised at 1.6% yoy in January and we expect it to remain on a sideways trend in the immediate future. However, there is a risk that the stronger dollar and second round effects from the fall in oil prices have a bigger effect on core inflation than we are currently expecting.

Global activity data generally encouraging

As in the eurozone, economic activity data elsewhere in the world were also generally encouraging. Early manufacturing PMI data from Markit from the US and China rose in February. The CPB’s indicators for world trade and industrial production were are also positive. World trade was up by 0.9% mom in December, more than reversing a 0.6% decline in November. Global industrial production was up by 0.4% following a 0.5% rise the precious month.


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