Euroland
A Perfect Landing
March 29, 2007

By Eric Chaney | London

(This is an extract from our monthly detailed report on the euro area, Euroland Business Cycle Watch)

In last month’s Business Cycle Watch, we mentioned “significant upside risks to our 2007 GDP growth forecast for the euro area”.  Another round of strong business surveys has convinced us to act, and raise our GDP growth forecast from 2.3% to 2.5%: the sharp slowdown in early 2007 that we had feared, because of fiscal and monetary tightening, has not materialised.  The message conveyed by the 15,000 or so manufacturing companies surveyed every month in the euro area is neat:  demand from local and foreign customers is still growing at fast speeds, inventories are insufficient, and production, although less buoyant than at the end of last year, is growing at a robust clip.  Moreover, thanks to strict management of inventories during the boom period, a sharp slowdown in the second quarter looks unlikely, even if demand growth slows to rates more in line with long-term trends. 

Where is all this demand coming from?

To our surprise, overall demand has not slowed, despite sluggish growth in the US and tax increases in Germany and Italy.  Since business surveys do not allow for disentangling of overseas demand (sourced outside of the euro area) from domestic demand, we have to make estimations.  First, US demand may have partially recovered after the contraction posted in 4Q (imports were down 1%Q in volume terms).  However, given the current weakness of the US economy, its contribution to an increase in global trade is unlikely to be significant.  Then, what about Asia, the engine of the global economy?  EU exports to China accelerated sharply in September-November last year.  On a year-on-year basis, German exports accelerated to a stunning 59% rate in November (32% for the euro area).  The reason behind this boom was the unsustainable acceleration in fixed investment in China, both on government-sponsored infrastructures and FDI-related projects.

Was the Chinese boom partially artificial?

I would not exclude the possibility that local authorities in China were aware of an imminent tightening by the central government (see Stephen Roach’s Unstable, Unbalanced, Uncoordinated and Unsustainable, March 19) and pushed ahead some key projects beforehand.  Besides, EU exports to China contracted significantly in December.  Since then, Chinese imports may have re-accelerated; this is at least what Taiwan export orders are suggesting.

Robust domestic demand remains the main engine

German retail sales were sharply down in January: broad sales dropped 9.6%M in January after +4.4%M in December (a number significantly revised upward).  Past VAT episodes suggest that the January correction should be followed by a rebound.  In addition, better employment and wage prospects should help consumers to open their purses.  However, the consumer sector is not yet the main driver of the recovery.  Instead, it is corporate investment.  Credit and loans to non-financial companies were up 12.6%Y in February, with long-term credit growth at 12.3%Y.  This duration typically finances corporate investment.  More puzzling is the 19.8%Y growth rate recorded by 1-5Y loans to non-financial companies (20.8%Y in January).  We suspect that private equity firms, which generally have a 3- to 5-year time horizon when undertaking a leveraged buy-out operation, are partially responsible for this boom in medium-term credit.  In that case, credit data could overestimate the ‘real thing’, i.e., capex.  However, since long-term loans are three times as big as medium-term ones, the bigger picture is that corporate investment and, to a lesser extent, consumer spending are the main current drivers of demand in Europe, despite the German VAT hike.

A perfect landing, decoupled from the US

Back to the short-term outlook, our survey-based indicators continue to anticipate a slowdown in 2Q.  Our early GDP indicator is hinting at above-trend growth in 1Q (0.7%Q), but, because this indicator was too conservative in 4Q (predicting 0.7%Q versus 0.9% actual), a lower reading is likely.  We have thus upgraded our 1Q GDP forecast from 0.3%Q to 0.5%Q, trusting the positive assessment made by companies.  We leave our forecast for 2Q unchanged at 0.5%Q, which means that, if we are correct, euro area economies are achieving a perfect landing in the first half of this year (0.5%Q is the trend rate), in contrast to the US.  At this stage, decoupling looks a reality.

So what’s next?

Initially, we thought that the German-Italian fiscal tightening would cause a significant slowdown in Europe in the first half of this year.  The facts show that we were wrong.  Neither a super-strong euro, nor a 3-point VAT increase in the largest European market nor a 175bp monetary tightening have managed to derail the economy.  As we have previously argued, the underlying strength of the economy is the main surprise coming from Europe.  On our estimates, euro area GDP would have grown by 3.5% last year if the exchange rate, oil prices and interest rates had been constant.  However, cyclical factors matter.  In the coming months, a further slowdown in the US (not to mention a recession) and a less buoyant Chinese economy could weaken European export momentum.  By themselves, we think that these would not be enough to threaten the recovery, since GDP growth is fuelled by domestic demand.  However, there is no Chinese wall between domestic demand and global growth: companies’ expectations, on both profitability and demand, are highly sensitive to the state of the global economy.  In a global downturn, they would be quick to cut investment projects.  In addition, the negative impact of fiscal diets on domestic demand may appear later than we previously thought; estimating time lags is an art more than a science.  Hence, while our central case scenario is still a re-acceleration of growth in the second half of the year, risks might be tilted to the downside, contrary to what we thought only three months ago.  It remains that, for the third time in a row, we are upgrading our GDP forecast for 2007.  Not bad for a region supposed to be condemned to stagnation not so long ago.

Euroland
Tweaking the Timing of Our ECB Call
March 29, 2007

By Elga Bartsch | London

In the light of the upward revision to our 2007 Euroland GDP growth forecast from 2.3% to 2.5% (see A Perfect Landing), we are tweaking the timing of our ECB interest rate hike forecast.  More specifically, we are bringing forward into the second half of this year the further 50bp of refi rate hikes we see for the ECB in the current phase of the tightening cycle, thus taking on board the risks we have been signalling for a while.  We now expect the ECB to pull the trigger on interest rates again before the end of the second quarter.  Thus far, we had been looking for another rate hike before the August summer recess and had hinted at July being the most plausible timeframe.  But as the slowdown in euro area GDP growth to a below-trend rate in the first half of this year does not seem to be materialising, we now deem it more likely that the Governing Council will use the opportunity of the publication of the June quarterly staff projections to raise its key policy rate to 4%. 

June as the most likely timeframe for the next ECB rate hike is also what our ECB Refi-Meter model suggests (see EuroTower Insights: When Will the ECB Stop? October 10, 2006).  The model is a simple statistical tool that provides us with an estimate of the probability of an ECB rate hike at one of the next three meetings based on a small number of economic indicators.  These variables include business sentiment, inflation expectations and money supply and loan growth in the euro area.  Having correctly predicted the timing of 10 out of 13 ECB rate hikes, the model now puts a high probability on another hike in June.  While we would not mechanistically tie our euro area interest rate forecasts to a statistical model, we take heart from the fact that our assumptions based on our own reading of the economic data and the ECB communication seem to be borne out by an empirical estimate of the ECB’s reaction function.

Currently, the market is only pricing in a 65% probability of a rate hike by June, and no further meaningful tightening of monetary policy thereafter.  In our view, the market is too complacent about the ECB interest rate outlook.  For starters, the market is completely discounting the idea of an ECB rate hike at the May meeting.  In our view, however, the risk of an early rate hike cannot be completely ignored.  The language chosen at the last press conference, when ECB President Trichet stated that the upside risks to price stability warranted very close monitoring, indicates that the ECB wants to keep its options open for an early move (see ECB Watch: What Marching Orders for Monetary Policy? March 8, 2007).  The appeal in moving early would be that the ECB could act pre-emptively with respect to the ongoing wage negotiations in Germany, before the ink has dried on the 2007 wage deals.  The timing of the Governing Council meeting on May 10, which will take place in Dublin, also puts it in the diary after the French presidential elections.  At the same time, the external risks to the euro area recovery seem to be on the rise right now, and downside surprises on US growth and the USD cannot be ruled out.  But the incoming data also show that the domestic demand revival is more robust than expected.  Hence the Council might want to wait until it sees a fresh set of staff projections at the June meeting.   In addition, with the ECB getting closer to a pause in the tightening cycle, raising the pace of tightening again might also send the wrong signal to financial markets about the extent of the ECB’s inflation concerns.

Looking beyond the next refi rate hike, we expect the ECB to hike once more in the remainder of this year.  In other words, our year-end refi rate target now becomes 4.25%, up from 4.0% previously.  This compares to market expectations for a 4% peak in the refi rate.  Previously, we had pencilled in a 4.25% refi rate only for early 2008, in response to renewed momentum in euro area growth in the second half of this year.  But now that the soft patch we had expected for the first half does not seem to be materialising, we believe that the ECB will likely complete its tightening campaign by year-end.  Note that the change to our forecast only refers to the timing of the ECB’s interest rate moves.  As before, we expect the ECB to take an extended pause once it reaches 4.25%.

On the back of the tweaking of the timing of our quarterly forecast profile for the ECB policy rate, we have also updated our bond yield forecasts and slightly raised our year-end target for 10-year Bund yields to 4.5%, from 4.4% previously.  While we acknowledge the possibility of further bull-steepening, especially at the front end of the curve, as long as the market discounts the ECB’s resolve to nip in the bud potential inflationary pressures, we believe that it will have to give way to a bear-steepening eventually.