Euroland
Much Better on Bottom-Up
October 15, 2009

By Elga Bartsch & Daniele Antonucci | London

Summary and Conclusion

Our business cycle analysis revealed a major discrepancy between the muted swings our top-down GDP indicator was predicting and the much greater gyrations our bottom-up GDP indicators for the large euro area countries were showing.  Based on the latter, we are revising up our near-term GDP estimates.  In particular, we are raising markedly our estimate for 3Q GDP growth to 0.9%Q (from 0.2%Q before) on the back of a more vigorous turnaround in the inventory cycle than we had anticipated so far (see Inside the Inventory Cycle, February 16, 2009).  As a result, we are also revising up our full-year GDP estimates to -3.7% for 2009 and to 1.2% for 2010, from -4.0% and 0.8%, respectively.  While this marks a cumulative change of 0.7pp, the upgrade does not change our fundamental view that the recovery is likely to remain lacklustre.  This is by no means a V-shaped recovery.  Even with such a smart rebound during 3Q, GDP would still sit 4.3% below the peak.  In addition, a sustainable recovery in domestic demand is still far off, we think.  On the contrary, the inventory-led bounce could well set us up for disappointment further down the line.  We are concerned about a sizeable gap between inventories and orders that has emerged in the last few months and which could potentially be a warning sign of a double-dip at the turn of the year. 

Top-down analysis misses important bottom-up information. Our euro area GDP indicator had failed to fully capture the extent of the downturn.  This caused us to signal upside risks to our near-term GDP estimates in the euro area for a while (see European Economics Chartbook: The Recession Seems to Arrive Early, August 14, 2009) because the indicator's inability to capture big swings in activity on the downside could also imply that it would fail to do so on the upside.  Subsequently, we had wondered why this could be the case.  It now turns out that the reason is straightforward: a bottom-up indicator based on the main euro area countries deviates very significantly from the top-down estimate for the euro area as a whole.  In fact, the bottom-up estimate tracks actual GDP dynamics a lot better than the top-down.  At the current juncture, it points to very substantial upside risks to near-term GDP growth.  This discrepancy between top-down and bottom-up likely reflects that the official euro area GDP is estimated based on national GDP reports.  Contrary to our top-down indicator, it is not based on euro area industrial production.  In normal times, this did not make a big difference.  But it seems to matter a great deal now.

Bottom-up estimate hints at sizeable upside risks to GDP growth. Following the release of stronger-than-expected August industrial production data in several large euro area countries, we dusted off our national GDP indicators and ran the models for the large euro area countries to see what the implications for 3Q GDP were.  To our surprise, the indicators hinted at some major upside risks to near-term GDP estimates. Aggregating the country models suggests that, for the euro area as a whole, GDP could have expanded by as much as 0.9%Q (or 3.6% SAAR) between July and September.  This compares to our cautious forecast of 0.2%Q previously and a top-down indicator estimate of just 0.1%Q.  In terms of the countries, the main upside surprises emerged in Italy (where industrial production surged a substantial 7%M in August) and France.  Meanwhile, there were only small discrepancies relative to our official forecasts in Germany and Spain (see Germany Industrial Production - Production Recovers as Expected, October 7, 2009).  While the indicator estimates for 3Q can be considered relatively robust (as they are based on information up to and including August and therefore already incorporate 89% of data determining the overall 3Q growth rate), the indicator estimates for 4Q should be seen more as ‘guesstimates' (with only 11% known). As a result, we take the 3Q upside risk on board in our forecasts, but stick to our 4Q forecast of 0.3%Q, which is a tad below the indicator.

We revise up our full-year GDP estimates.  Bearing in mind what the indicators are tracking currently and factoring in some sizeable corrections in industrial output in September, we thus believe that 3Q EMU GDP could have expanded as much as 0.9% (3.6% SAAR).  With the 4Q GDP indicator estimate being close to our official forecast, we get a new full-year estimate of -3.7% for 2009 GDP and, importantly, of +1.2% for 2010 GDP. This forecast change marks a cumulative upgrade of 0.7pp relative to our previous forecast of -4.0% and 0.8%, respectively.  Importantly, the forecast upgrade does not change our fundamental assessment that the deepest recession in post-war history in the euro area will be followed by lacklustre recovery.  This is by no means a V-shaped recovery. Even with such a smart rebound during 3Q, GDP would still be 4.3% below its early 2008 peak.  In our view, a sustainable recovery in domestic demand is still far off, as capacity utilisation rates are still near rock-bottom and unemployment is set to rise further.  Alas, as the upside near-term surprise is due to a turnaround in the inventory cycle, it is also likely to be short-lived.

Something strange is going on inside the euro area inventory cycle.  The inventory-led bounce is likely to be short-lived because a worrying gap has started to build between companies' assessment of inventories and their view on demand, i.e., order books.  Historically, both demand and inventories have moved closely together.  But in this cycle, they started to diverge about half a year ago when companies became more optimistic on their inventories - probably on the back of previous aggressive cutbacks. So far, however, companies have only reported a small improvement in their order books.  As a result, a sizeable gap between inventories and orders has emerged.  This gap, which we will be watching in the coming months, can be closed in two ways: either demand catches up or inventories are viewed less optimistically. 

This could be a warning sign for a double-dip.  Stagnating order books, correcting output plans and slowing current production reported in the September business surveys already signalled that the recovery could be losing momentum.  Hence, the near-term upside risks stemming from the inventory cycle do not make us more confident about the medium-term recovery. On the contrary, inspection of country data shows that those countries for which our GDP indicators signal the largest upside risk are also the ones that have the biggest gaps between inventories and order books. 

Implications of a near-term growth spurt for the ECB policy outlook.  If our bottom-up aggregation of national GDP indicators is anywhere close to the official 3Q GDP numbers to be reported in mid-November, substantial upside risks to the ECB staff projections would arise.  Currently, the ECB staff is projecting GDP growth to only average 0.2% next year.  Our new full-year forecasts would suggest upside risks to these projections of a full percentage point.  Such a noticeable upgrade in the full-year growth projections could potentially trigger a change in the ECB's assessment of its monetary policy stance.  It does not necessarily have to trigger a change in the tone of the introductory statement, though, as the staff projections aren't underwritten by the ECB Council.  If the ECB staff share our view on the upside mainly being down to the inventory cycle, the monetary policy implications might also be minimal.  But they could still spook markets.

New ECB staff projections aren't due before the December meeting.  However, it is possible that ECB President Trichet will want to prepare markets at the November press conference.  By the time of the December meeting, the ECB staff will also have a much better handle on indirect tax hikes planned across the euro area and their implications for HICP inflation in 2010.  Given the rising budget pressures, we would expect these to make a more meaningful contribution.  In addition to factoring in the new staff projections, the ECB Council will have to decide on the interest rate at which the next one-year tender conducted in late December will be offered.  It could potentially decide to offer it at a small spread over and above the refi rate.  In sum, the December ECB meeting could potentially ring in an important change from the dovish tone characterising the last few press conferences.  That said, we continue to see the ECB on hold until around mid-year - possibly even longer.

Country Forecast Highlights

France - Taking Stock of the Inventory Cycle

The short-term outlook for France has improved notably.  We now expect 2010 GDP to grow by 1.7% in 2010, up from our previous forecast of 0.9%.  This is mostly due to a likely boost to GDP growth in 3Q09, which will raise 2009 GDP from our previous expectation of -2.2% to -1.8%.  France has weathered the global recession better than any other major euro area economy, contracting by just over 3% from peak to trough compared with a drop of twice that size in Germany.  Two factors account for the lesser decline - France's more limited reliance on exports and the resilience of the French consumer.  Conversely, the industrial sector suffered as much as in Germany.

However, the recent pick-up in industrial production suggests that economic activity might accelerate between 3Q and 4Q.  In the scenario that we envisage for the remainder of this year, the main driver behind the pick-up in GDP growth is that manufacturers are likely to replenish their stocks of inventories after sharp cuts this winter, as suggested by the various business surveys - ranging from the INSEE business sentiment to the manufacturing PMI.

The upshot is that the so-called hard data, especially on the manufacturing side, are likely to surprise on the upside over the next few months.  Indeed, Morgan Stanley's proprietary GDP indicator points to an increase in 3Q GDP to the tune of 1.1%Q - which now happens to be our official forecast too.  However, there is a non-negligible risk that we might see a fall back in 4Q, unless domestic demand starts to strengthen more visibly.

Italy - Manufacturing Catch-Up

The data flow turned decisively positive in Italy.  We have revised up our 2010 GDP forecast from 0.6% to 1.2%.  But don't hold your breath: although 2H09 is shaping up as much stronger than could have been envisaged only a few months ago, our medium-term view has not really changed.  We now predict a contraction this year to the tune of 4.5% versus a previous forecast of -5.1%, on the back of a brighter short-term outlook for the industrial sector.  For example, industrial production printed a 7% monthly gain in August - the strongest reading in 30 years - dwarfing the median forecast of 1.5%.  What's more, this followed an upward revision to the previous number from 1.0% to 2.4%.

This points to sizeable upside risks to 3Q GDP growth.  Even assuming a payback in September as big as the gain in August, industrial production is likely to have increased by around 5%Q in 3Q, quite a turnaround after five quarterly contractions in a row.  Morgan Stanley's proprietary GDP indicator also points to a quarterly gain of 1.2% in 3Q - far above the latest published consensus forecast of 0.5%.

This forecast already factors in notable downside risks.  Indeed, most of the boost in 3Q is due to companies re-building their stocks after severe cuts this winter.  This means that this impulse will fade away once companies feel that their stock of inventories is adequate.  We expect GDP growth to be flat in 4Q and to average about 0.3% per quarter next year.  In addition, Italy is - together with France - the major euro area economy with the biggest discrepancy between the assessment of inventories and orders.  This suggests that companies expect demand to remain weak.  The pick-up in economic activity might turn out to be very short-lived, unless more fundamental drivers of growth kick in.

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Global
Bigger than the Big 5
October 15, 2009

By Manoj Pradhan | London

When Reinhart and Rogoff compared the US financial turmoil favourably to the five biggest financial crises in industrialised countries in recent years, it was still early 2008. Too early, it turns out, with the benefit of hindsight. Since then, the wake of the financial turmoil and its economic ripples have swept beyond the economic fallout seen in the Big 5 (Spain '77, Norway '87, Finland '91, Sweden '91 and Japan '92) and quite easily past the pains of the last four recessions (Last 4) in the US. Comparing the latest crisis and the ensuing recession with its peers of the past reveals some of the potential pitfalls and policy dilemmas that have yet to be successfully negotiated.

First, evidence from the past suggests that crises and recessions are generally followed by benign inflation. Second, policymakers in the Big 5 were able to moderate policy because the risks of deflation had abated, while the Fed was able to depend on a robust recovery in the Last 4. Finally, the experience of these episodes emphasises our long-held view that economic recovery leads to a resumption in lending, but credit and output growth are seemingly locked in a symbiotic embrace thereafter and need each other to post a sustainable recovery. None of these relationships can be taken for granted at the present time, which raises the risks associated with the withdrawal of monetary policy. The transitions in past recessions from a resumption of growth to an entrenched recovery were not without risks. Comparisons with the Big 5 and the Last 4 suggest that downside risks to medium-term growth persist for the current recovery from at least two sources. First, credit may not follow the script laid down by history and may show only a flimsy revival, curbing medium-term economic growth. Second, if growth surprises to the upside in the short term and inflation expectations subsequently rise, policymakers may follow the script laid down by history and tighten policy. This would put the fledgling economic recovery at risk. In a previous note, we have highlighted that the risk of such a premature tightening is the one that seems more likely now that downside risks have abated (see "‘Up' With ‘Swing'?", The Global Monetary Analyst, September 16, 2009).

Output and inflation have fallen faster than in the past: GDP and inflation have fallen more sharply and by at least as much if not more than previous episodes in the Big 5 and the Last 4. However, unlike previous crises and recessions, the fall in output and inflation has been mirrored across the globe but the recovery from the recession differs widely from region to region. Our global team continues to expect Asia to outperform the rest of the world, while the G10 is likely to post weak growth. Data out of Latin America have recently shown signs of a robust recovery, but the CEEMEA region remains a laggard, as central banks there have not yet completed much-needed policy easing. For a global economy that saw growth dip into negative territory in 2009, the shape of the recovery in the G10 remains a crucial factor.

Economic recovery has come earlier than it did for the Big 5: With US and global economic growth rebounding in 2Q09, the recovery from the current financial and economic downturn has taken longer than the average recession in the US but less time than the average recovery in the Big 5. Clearly, the globally synchronised, aggressive monetary and fiscal policy programmes put into place have helped tremendously in cutting down the recovery time. This policy support is expected to stay in place for a considerable period of time, and therein lies the risk that growth could surprise to the upside over the next few quarters. Central bankers are likely to keep monetary accommodation in place for a significant period, and some have even advised markets that rates will remain low for longer (conditional on inflation, of course). Even where policy rates have been raised early (Israel and Australia so far, with Norway expected to follow this month), the increases are unlikely to be uniform all the way back to neutral. QE programmes in the US and the UK have been extended in scope or maturity time and again and still have a way to go before asset purchase targets are achieved. Finally, fiscal policy packages around the world were typically multi-year programmes that will continue to provide stimulus well beyond the recovery. In the US, for example, Recovery.gov reports that only around US$110 billion of the approved package of US$787 billion (22%) has been spent so far.

Monetary policy has been much more aggressive than in the Big 5 or Last 4: The aggressive monetary policy response can be seen clearly in policy rates, bond yields and money growth on a comparative basis. Thanks to rate cuts and QE, the fall in policy rates and bond yields has outstripped those seen in the Big 5 and the Last 4, producing significantly easier monetary conditions. Money supply increased in the Big 5 by nearly 15% on average, but this is still less than the 20% (so far) increase in the money supply under the ongoing QE regime. Crucially, policymakers back then curbed the growth in money supply about a year into the turmoil, which is in stark contrast to our expectations for excess reserves and money supply to continue to grow two years after fixed income markets first froze up. The US$420 billion of QE asset purchases yet to come and the wind-down of the SFP programme together set the stage for an increase in excess reserves held by financial institutions at the Fed from US$918 billion now to about US$1.25 trillion by early 2010, according to our Chief US Fixed Income economist, David Greenlaw. We believe that this will provide continued support for M1 growth. M1 is currently growing at 17%, 15% and 26% in the US, Euro Area and the UK (M1 proxy), respectively, suggesting that economic recovery and asset markets will likely continue to benefit from policy tailwinds.

Inflation risks are higher this time round: The size of monetary and fiscal packages along with the declining importance of the domestic output gap in determining domestic inflation are sufficient reasons to be watchful for rising inflation as the economic recovery becomes entrenched. Money supply, when allowed to grow and stay large, has resulted in higher inflation on more than one occasion (see "Could Hyperinflation Happen Again?" The Global Monetary Analyst, January 28, 2009). In addition, our empirical work suggests the domestic output gap has become less important in determining domestic inflation (see Global Fixed Income Economics: Inflation Goes Global, July 16, 2007). Even if that view is challenged, the size of the domestic output gap remains a contentious issue. The CBO's measure of potential output puts the output gap at approximately -7%, but our own estimates show that the output gap could be as small as -2% due to a sharp fall in potential output. In his academic work prior to joining the ECB, Governing Council member Athanasios Orphanides underscores this issue by pointing out that the errors in estimating the output gap could be as large as the output gap itself.

Less leeway on inflation this time round: Policymakers in the Big 5 were able to pull back the strong monetary stimulus because the risk of inflation had abated, while US policymakers could tighten policy because growth had become entrenched and inflation expectations were beginning to rise (see "Growing Pains", The Global Monetary Analyst, September 23, 2009). This time round, central bankers have to contend with inflation risks from global sources, as well as the difficulty in unwinding sizeable QE programmes and raising rates from nearly zero at the right time and speed to prevent inflation risks from being triggered. With little margin for error, the balancing act carries more risks than ever.

Recoveries lead lending, but recoveries also need lending: Comparing GDP growth and credit growth shows a wedge between the recovery paths of the Big 5 and the Last 4 versus a similar gap in credit growth between the Big 5 and Last 4 that could account for at least part of the growth differential. Evidence from individual episodes from the Big 5 and Last 4 shows the relationship between output and credit growth quite clearly. As we have argued before, credit growth resumes only after economic recovery has taken place. However, once economic recovery creates favourable conditions for both lenders and borrowers to re-enter the market, robust growth in credit is likely an important ingredient for a sustained recovery. The path of output and credit growth from past episodes suggests that economic recovery tends to be correlated with lending - at least part of this correlation is likely to result from an improvement in credit growth leading to better economic growth. Thus, while we expect credit growth to pick up as the recovery improves borrowing and lending conditions, the risk of weak credit growth weighing down on economic recovery cannot be ruled out.

As such, we have highlighted two sources of downside risks for a sustained G10 and hence global recovery. One is the premature withdrawal of policy support if economic growth surprises to the upside and raises inflation expectations, and the other is the downside risk directly from weak credit growth. These two need not be independent of each other - credit growth would also likely suffer if policy were to be tightened prematurely. A volley of speeches from major central banks has argued time and again that they possess all the tools necessary to withdraw the monetary stimulus when required. There is no doubt that they do. What is yet open to question is whether they will be able to deploy these tools to mop up excess liquidity at the right time and with the right speed. Evidence from major crises and recessions in recent economic history suggests that a benign outlook for inflation and rising inflation expectations have played an important role in determining the timing and extent of withdrawal of monetary stimulus. This time round, the tightrope is thinner and much higher above the ground.

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