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Thursday, June 21, 2007

The Eurozone - Mixed Data Suggests a Blurry Outlook

(Update Added Below)

By Claus Vistesen Copenhagen

The biggest news in Europe at the moment could hardly be said to represent the economy which for all intent and purposes is moving along just fine (or is it? we will see below). Rather, the interesting issues at the moment seem to be what Sarkozy, with his recent second-time victory in the national assembly, will do in terms of labour market reforms and the promised fiscal strategy (see latest entries and sources on Eurozone Watch and Eurointelligence for much much more on this). Also and perhaps more important it seems as if the political stage in Europe, after having spent more than 2 years on the canvas following the knock-out from the French and Dutch refusal to the Constitution, is finally read to take up the baton again on the summit starting today in Bruxelles. This time it seems as if the playbook prescribes that the constitution (or whatever we call it) should be stripped for anything which might, oh dear oh horror, lead to a popular referendum in member countries. Once bitten, twice shy it seems. Perhaps though, Europe's political leaders should be less worried this time around as this FT article reports that support for the European Union amongst member states' population is at an all time high mainly on the basis of the strong economic sentiment.

But then again, what is it with that economy?

Let us begin with zone's largest economy Germany. The first thing to note here is that investor confidence declined in June for the first time in several months. This of course should be seen in the context of recent months' buoyant sentiment but it still suggest, as I have noted on several occasions recently, that growth in the Eurozone is waning off going further in 2007. More importantly on Germany is to gauge the perceived inflationary pressures from past and upcoming German wage round negotiations, something which has promted much attention from the ECB as of late regarding the impetus to continue raising rates. First of all we learned that annual wage costs rose by a puny 0.1% in Q1 2007 something which I personally find somewhat surprising even if I did not, in the first place, believe that the German labour market would be the source of much wage push inflation. Another cyclical indicator which was published recently was the German PPI data from industrial production (domestic sales) showing a 1.9% increase y-o-y. This was then noted by Bloomberg as the slowest decline in three years and it further suggests that the inflation bug migh not be as bad as imagined. Remember also here that PPI data is a lagged indicator of wage pressures. Regarding the general inflation data from Germany and the Eurozone the HCIP showed a stable rate of 2% in May just above the Eurozone average of 1.9%. Coupled with recent data on domestic demand operationalized by retail sales which still seem to fall short of this self-sustaining recovery narrative the main issue, I think, still revolves around just how strong domestic demand is in key Eurozone countries. Of course, in Germany we always need to remember the external trade balance and what is still, quite frankly, remarkable performance figures. As such the German statistical office just adjusted the surplus for 2006 to EUR 164.6 billion which signifies that the value of exports exceeded the value of imports by a whopping 22.5%. At the present juncture this of course somewhat backward looking but it still suggests that exports remain very strong in Germany from a general structural perspective.

However, turning to the latest data from the Eurozone as reported by Bloomberg we also see that momentum is still very much present. Consequently, the European services and manufacturing industries expanded in June as measured by the indices from Royal Bank of Scotland Group. However, we need to remember that this is for the entire Europe and not exclusively from the Eurozone. Moreover, especially foreign demand is cited for the continuing impressive demand which once again conforms with my general skepticism towards the sustainability of domestic demand in key member countries. In fact, this quote right at the end of the Bloomberg article paints a rather different picture on the Eurozone economy ...

Rising borrowing costs and the strength of the euro may curb the pace of growth in the second half of the year. The euro has risen almost 7 percent against the dollar in the last 12 months, making European exports more expensive abroad.

Manufacturing orders in Germany fell for the first time in three months in April, and French and Italian industrial production both unexpectedly declined. French consumer spending on manufactured goods fell last month, while the ZEW gauge of German investor confidence unexpectedly dropped in June.

The data still prompted the FT's Ralph Atkins to note how the Eurozone is regaining momentum but as I note above we should think how much of this for foreign demand. In fact, I would argue that the supply/demand dynamics and thus also capacity dynamics here are blisfully unaccounted for in these generalized indices. Note especially here how the Eurozone on aggregate is actually running an external surplus with the rest of the world and has been doing so since Q3 2006. Of course, this masks important cross-country differences but still I think it is an important part of the equation. And then my favorite in terms of future inflation pressures ...

The ECB on June 6 raised its key rate to 4 percent and indicated further moves may be in the pipeline to contain inflation. The measures of input and output prices in today's composite PMI report both increased.

``This could be of concern to the ECB, which had highlighted the risk of high capacity utilization boosting inflation,'' said Sandra Petcov, an economist at Lehman Brothers in London.

I have no time at this point to go into this but reading through Edward's recent posts here at GEM you should get an idea. I mean, just who knows why capacity is declining at this point? And what happens on the flipside of this cycle if capacity in key economies is inelastic to the stimulants offered by monetary policy? I will tell you what, deflation! Ok this might be a scare monger scenario but I do feel as if we are playing into something here which is not very well understood.

To substantiate the after all mixed recent data, we get the recent evidence from Italy where consumer confidence dropped to a one year low in June. Given the relative sluggishness of the Italian economy in the Eurozone this does not at all make me happy given the perceived trajectory of the ECB in the rest of 2007. My guess is that the Italian economy might slow further and with the annualised growth rate from Q1 of 1.2% (0.3% in Q1) there is just not much slack to draw upon! Also, in France the signs from the hitherto strong French consumer dissapointed with consumer spending dropping in May; see original INSEE note here (in French). And please note the political sub-current here ...

``France has a purchasing-power problem,'' Sarkozy told lawmakers yesterday in Paris. ``Salaries are too low and prices are too high.''


The decline last month may reflect higher interest rates, said Jean-Christophe Caffet, an economist at Paris-based Ixis. ``We're seeing a slowdown in credit,'' he said. The European Central Bank this month lifted its benchmark rate to a six-year high of 4 percent.

My guess is that we will, very soon, see the ECB taking heat as many times before from various political angles. Of course, this has not and should deter the central bank but it does tend to make things more complicated.

The last thing I want to comment on in this note on the Eurozone is the recent data on construction output. On a seasonally adjusted basis output fell in April from March by 0.9%. On an annual basis growth was positive but significnantly lower in April than it was in March. It is of course difficult ot discern a general trend from this but we need to hold this together with the data showing a slowdown in mortgage lending in the Eurozone. As such, at some point the ECB's hiking campaign is going to bite and one of the areas is of course regarding home mortgages and as such also construction activity. I am not saying that the construction industry in Spain for example is crashing; it clearly is not. But to the extent that the housing market in many Eurozone members have been very hot lately (e.g. in Spain, Ireland, Greecen and France) this is clearly going to come off the its high ground now even if it is not in any sense of the word crashing. All this is difficult to say without digging much deeper into the specifics but still it is something to watch out.

In Summary

The only thing missing here is of course an interest call on the future course of the ECB in 2007. In many ways, I have already dealt with this in my previous notes on the ECB decision to take the refi rate to 4% a few weeks back. For all intent and purposes it is very difficult, at this point, not to expect the ECB to take it to 4.25% at some point in 2007. Both the recent remarks from the ECB, the Euribor futures markets as well as forecasts from Morgan Stanley indicate this. I remain skeptical on this and I clearly do not agree with Morgan Stanley when they open the door to a refi rate as high as 4.75%; this I think is highly unlikely. What I think is important is that the ECB from here on quite simply have to become more data dependant as it clear that restrictive territory is moving ever close if the threshold has not been passed already, at least in Italy's case. In that respect, the data fielded above paints a less favorable picture than the ECB had expected or at least, this would be my guess. Also, at some point it will be interesting to see whether the ECB can keep on maintaining its cyclops eye fixed on aggregate inflation and monetary measures. As for my official interest rate call I have nudged it up to 4.25% based more on what I think will happen than I think should happen. One thing I think however to be crucial is the incoming real data on domestic demand in Germany and Italy.