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Tuesday, February 20, 2007

4th Quarter to the Rescue?

By Claus Vistesen: Copenhagen

Earlier last week figures for Q4 growth in Japan and the Eurozone came out and by and large the reports make for very comforting reading accentuating the notion of 2006 as a very good year for economic growth in both the Eurozone and Japan. In my initial notes here at GEM I have maintained a rather pessimitic tone towards growth prospects in the Eurozone pointing most notably to long term structural factors, but also looking forward to 2007 I see the potential signals for a marked slowdown in key member states in the Eurozone itself and in Japan. Yet, as the Q4 figures have rolled in this week and the commentaries have appeared, we find ourselves right smack into the same old optimistic discourse. In the Eurozone the commissioner for monetary affairs Joaquin Almunia was quick to up the forecast for 2007 Eurozone growth pointing simultaneously to the robust and Eurozone wide recovery. You could even hear amongst some commentators mention of the illusive concept of a goldilocks recovery resurfacing. In Japan, the optimism amongst market watchers was also almost uncontainable although some still recognise that domestic consumption constitues an ever enduring weak spot for this proclaimed sustainable Japanese recovery.

So what do the numbers say and what should we expect going forward?

Eurozone - Enough Honey in the Pot?

The 4th quarter figures for the Eurozone were an overall comforting read. Relative to the Q3 figures of 2006 where the Eurozone grew 0.5% q-o-q growth rebounded somewhat to 0.9% q-o-q. So what happended? First of all, and quite surprisingly I have to say no one seems to link this rebound in Q4, at least to some extent, to the French economy where, as we might remember, there was a quite surprising 0% q-o-q growth rate in Q3. In Q4 France grew by 0.6% over the previous quarter, which translates into a 2006 growth clip at an annualised rate of 2.2%. Obviously, the 4th quarter is not all about France since Germany and Italy also reported strong growth rates above the earlier consensus forecast. In Germany, growth increased sligthly from Q3 (0.8%) to 0.9%. The reason for this is widely cited to be a pick up in domestic consumption as consumers chose to bring forward purchasing to avoid the three percentage VAT hike which came into effect on the 1st January 2007. I have not had time to consult the figures in terms of composition but generally the commentaries also confirm the picture of a German growth path which remains driven by strong export growth contributing significantly to Q4 growth too. This phenomenon of forward purchasing, especially of durable and capital goods, is also emphasized by MS's Eric Chaney in his note on the Q4 growth figures in the Eurozone. Actually, the German growth rate does not surprise me that much but Italy's does I have to admit. In Q4 the Italian economy raced ahead reporting a 1.1% growth rate q-o-q and here also the break-down of the growth components has not yet been given in the official data. However, intra-trade dynamics within the Eurozone and especially the sustained pace shown by Germany are noted as major contributors. However, as Eric Chaney also notes, external demand cannot be the sole driver for such impressive numbers for the 4th quarter. Lastly, we have Spain where growth also maintained a lively pace reporting 1.1% q-o-q which also translates into a very strong annualized growth rate of 3.8% (annualized quaterly figures) and close to 3.8% in y-o-y terms too.

So, all in all, there should be plenty of grounds for optimism and as such also grounds for the revival of the goldilocks recovery idea. However, the question remains, will there be enough honey to go around as we venture further into 2007? Well, both Eric Chaney's note as well as this analysis by Eurointelligence pretty much beats me to it in terms of calling and essentially maintaining my pessimism. There are at least two things which we all seem to agree on. First of all, as I have also persistantly been arguing since last summer, fiscal tightening is on the menu in 2007 in both Italy and Germany and given the nature of this tightening process which essentially is a proxy for personal savings I am weary for the outlook for consumer spending and ultimately the evolution in aggregate domestic demand in 2007. Secondly, there is the evolution of the US economy to think about, and although recent data continues to point to a 'soft landing' for the US economy on the back of a housing slowdown in Q3 and Q4 of 2006, the US economy is by no means out of the woods yet. Eurointelligence points to a recent note by Brad Setser in which the December Treasury International Capital report is scrutinized. The worrying data point is that private capìtal inflows have turned negative (at least temporarily) which of course brings into question the sustainability of the mounting US current account deficit. Stephen Roach from MS also has more on this in one of his recent notes. Yet, we also, of course, have commentators like Nouriel Roubini who has been busy pointing us to the possibility of impending credit crunch in the US. Lastly, I should also note that Eurointelligence seems to agree with me (or I with them) in terms of the questionability of the continued presence of inflationary pressures and whether or not the ECB really does need to remain so vigilant, at least on inflation grounds.

In this context we need to keep well in mind that liquidity/monetary measures such as, for example, M3 are not necessarily an accurate measure of inflationary pressures especially in the light of carry trading. Secondly, fiscal tightening is key member countries is also likely to have a deflationary effect on Eurozone aggregate inflation rates.

In the end I also need to point to the inability or reluctance of commetators to factor-in the sustained process of ageing in the Eurozone and especially Italy and Germany. As the ECB continues to pursue an ideal Eurozone-wide interest rate I fear that imbalances within the Eurozone itself might very well grow to become even bigger and as such the strutural growth path of key member countries may be pushed even more towards export dependancy. This is why I am so interested in consumer spending figures from especially Italy and Germany which provide an important test case for the hypothesis.

Japan - Expecting a Hike by the BOJ?

Turning over to Japan the Q4 also reported a healthy growth clip. From the third quarter the economy grew 1.2% which translates into an annual growth rate based on annualised quarterly figures of 2.2%. Of course the interesting thing here is consumer spending and here alongside the FT article linked above Takehiro Sato from MS provides the relevant figures in his note on the Q4 figures. The q-o-q figures show an increase in domestic demand in Q4 of 1% after a (-0.3%) decrease in Q3. This translates into an average q-o-q growth in domestic demand of 0.4% (0.35%) in the last two quarters of 2006. Turning to movement on a y-o-y basis, domestic demand grew 4.8% in y-o-y terms in Q4 but declined (-4.2%) in Q3 on a y-o-y basis. This consequently translates into a composite growth rate in the two last quarters of 2006 on y-o-y basis of a 0.3% increase. These figures are of course subject to continous revision and as the main sentiment goes we should perhaps be looking for a downward revision? Sato from MS also notes that consumer spending perhaps declined on a monthly basis in December relative to October and November. Turning to inflation, prices remain subdued and the Q4 did not see any notable move towards sustained inflation; in short, we are still hovering very close to negative price evolution. Sato has the relevant summary:

Among domestic demand deflators, the public and residential investment deflators remained in an upward trajectory, while the capex deflator also bottomed. Above all, the decline in the personal consumption deflator is hurting overall.

So what does this mean for the BOJ and future interest rate expectations? As I have already argued before following one of Takehiro Sato's points, the BOJ should be very careful about raising in March on the back of positive Q4 figures especially when the general trend in consumer spending figures and inflation is still very weak. MS apparently puts the possibility of a March hike at 50% (or marginally at 51%) which is the equivalent, in analyst-speak, of saying ... this could go either way. In the end, I think the BOJ decision should be pretty clear by now and evidently, if the main yardstick is to remain economic fundamentals, I do not see justification for a raise from the BOJ. However, there are other factors in play here, including pressure to unwind the carry trade as well as the perceived need and/or temptation to act on the Q4 figures. In the end I think that inflation will provide the strongest grounds for the BOJ to stay on hold as it is very likely that the first quarter of 2007 will see inflation dropping into negative territory as the headline reading continues to put downward pressure on prices. Finally, Takehiro Sato continued his Japan coverage last week by reporting that MS have recently upped their forecast for the Japanese economy. The above-mentioned reservations do however all remain, and as we stand on the brink of the next BOJ interest rate meeting we have reverted to a 'too close to call' stance by the markets.

4th Quarter to the Rescue?

So then, we should not be doomssayers here. Both in the Eurozone and in Japan 4th quarter economic data points to a solid growth towards the end of 2006, but what we are talking about here really is only data for one quarter and we should be looking at the bigger picture too, and also, crucially, the structural components of growth in the economies in question. As such, the fundamentals have not changed I think and ultimately this is why I remain sceptical on the ability of both these key economic regions to display the same kind of vigorous growth in the future that we have seen in the recent past. In fact, given the rather spectacular growth stint we have just been through, and especially in the Eurozone, we really should expect 2007 to be somewhat different. At the end of the day we need to think about just how to describe all of this and,crucially, we need to consider just what a 'sustainable' recovery actually means in the present context in the key economies? In Japan, 2006 was the year which marked (for the time being at least) the official ending of ZIRP was ended, but even exiting 2006, where it is widely recognised that growth was at an unprecedented rate in comparison to recent performance, interest rates have not been pushed up since the initial move which took Japan out of ZIRP in the summer of 2006. So, will 2007 finally be the year when this, after all, hideously slow normalization process really starts to take root? Perhaps, but perhaps not, and as I have stressed so many times on these issues we need to look at the structural components and what they mean. A 4th quarter rebound is indeed good in and of itself but whether it is a sign of maintained and sustainable strength is an entirely different question.