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Research Euroland: The Weakest Link

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Euroland growth was surprisingly weak in Q4 2009 with GDP growing a mere 0.1% q/q. France saw highest growth (0.6% q/q) among the larger euro area members, while Germany saw a flat GDP. Spain remained in recession (-0.1% q/q), while Italy slipped back into recession (-0.2% q/q) after a more impressive Q3 reading of 0.6% q/q.

The breakdown of growth in Q4 indicates that overall domestic demand excluding public spending remains weak and is pulling down activity, while public consumption stayed strong in Q4 supporting growth. Net exports contributed positively to economic activity in all major countries. Germany benefitted in particular from rising exports to the non-euro area, as exports to Asia have accelerated sharply in recent quarters. Despite the tiny growth unemployment has been stable at 9.9% over the past three months.

The latest data for retail sales and industrial production have been disappointing too. This bodes for a somewhat weak Q1 2010. It is difficult to gauge the effect from the hard winter across Europe, but we suspect that if anything it has been a drag on activity over the past couple of months.

While downside risks for Europe clearly have risen in the past months, we take comfort in more upbeat signals from "soft data". Manufacturing surveys indicate that new export orders accelerate, while employment components support our view that a labour market stabilisation may not be as far away as indicated by the GDP data. German business and consumer expectation indicators have improved too.

We have revised our growth projection for the whole of 2010 to 1.8% from 2.2%. The main reason is the base effect of the weak Q4 2009 GDP reading. Going forward we expect growth mainly to be supported by net exports, but we do also anticipate private spending and investments to gradually begin to lift economic activity during H1. We expect growth at 2.2% in 2011. This is an abnormally slow rebound, but growth is kept at bay by the fiscal tightening that will take place across Euroland.

Downside risks to our growth projections have in general increased. There is a significant risk that supportive measures will be withdrawn before domestic demand gathers momentum and labour markets stabilise.

In recent months we have seen several indications of lacklustre growth in Euroland and the news that GDP growth was "next to nothing" in Q4 was plain terrifying. Industrial production was on a strong upward trend from April to September 2009, but it then headed south and the latest figures show that industrial production in January 2010 was below the September 2009 in Germany. Retail sales are on a declining trend too, which was underlined by a 0.5% m/m decline in January. Manufacturing new orders in December were stable in Euroland, but fell notably in Germany. In January, German orders data however improve substantially.

If Euroland slides back into a double dip at the current juncture not much can be done. The gas pedal is already at full speed with the loosest monetary and fiscal policy ever. Not much more stimulus can be added. On the contrary, the next step is to take the foot away from the gas pedal - and with regard to the fiscal policy this will have to be done sooner rather than later.

What is really concerning is that if Euroland fails to show stronger growth in the coming quarters there is no chance that the labour market will stabilise and private consumption will not recover. We could then see a Japanese-like lost decade in Euroland. This is what keeps us awake at night.

Fortunately most of the forward looking indicators give more upbeat signals. German PMI manufacturing new orders index has risen strongly in recent months from an already high level of 55.9 in December 2009 to 61.7 in February 2010. This is at par with the peak in March 2006, and apart from that this is the highest level for the new orders index since 2000. This indicates sharply increasing German orders and production in early 2010 albeit from a low level. The aggregate Euroland manufacturing PMI new orders index shows the same development albeit at somewhat lower levels, as Spain, Greece etc are pulling the index down. Other upbeat indicators are the Ifo expectations index, which has risen for 14 months in a row and shows that production and export expectations on a three-month horizon are sharply increasing, and the OECD leading indicator for Euroland, which is still at a very high level.

Export market growth is very strong at the moment and the euro has weakened notably. The prospect is thus that exports will be a key driver of growth in the coming quarters. Euroland manufacturing PMI new export orders thus jumped from 53.8 in January to 56.0 in February 2010. The order-inventory balance still indicates that we can also expect a positive growth contribution from the inventory cycle in the coming quarters.

Another positive thing is that the labour market stabilisation may not be as far away as the dismal GDP growth data seem to indicate. For the past three months the unemployment rate has been unchanged at 9.9% although the number of unemployed is still increasing at a slowing pace. Manufacturing PMI - traditionally a good indicator of unemployment - indicates that a labour market stabilisation is imminent. The PMI employment indices have improved notably, although they still indicate further increases in unemployment. Unemployment is a strong driver of private consumption, so a stabilisation of the labour market will be a critical turning point for domestic demand. One more positive signal is that lending for house purchases is improving, driven by low interest rates, which also tends to signal that an improvement in private consumption is forthcoming.

In conclusion we are relatively optimistic that exports and the inventory cycle will be able to drive growth for a couple of quarters and that a labour market stabilisation is not that far away. The housing market is also seeing better days, driven by the very low interest rates. These factors will fuel a slow recovery in private consumption. Strong exports and an improved outlook for construction will also drive investments upwards. We expect to see strong investment growth later this year. Euroland is falling behind the US and Asia, but it does not look like a double dip at the moment. However, downside risks have increased and the urgent need to tighten fiscal policy in some countries before sustainable growth has returned is worrisome. We will not sleep well at night before we see reliable evidence of a recovery in domestic demand.

We have made projections of debt developments across Euroland until 2020 in the research paper "Debt on a dangerous path", 4 January 2010. In a no-change scenario Greek government debt will hit 238% of GDP in 2020 up from the current estimated 113% of GDP. The calculations also show that for most countries it will be almost impossible to fulfil the Stability and Growth Pacts 60% debt-to-GDP criteria within a decade. Greece would have to tighten the budget by 4% of GDP, not just in 2010 as planned, but every year for five years in a row in order to achieve this.

But what is most important for now is not to fulfil the Stability and Growth pact's criteria, but to regain market confidence and get access to funding on normal terms. In this respect Greece is moving in the right direction as it has put rather ambitious austerity plans forward. There have been strikes, but public support for necessary tightening is not as absent as one might think. A poll has shown that 75% of Greeks think there should be no strike action until the crisis has passed and 57 % thinks that the belt-tightening is going in the right direction.

Greece has so far received nothing but verbal support from the rest of Euroland. The Commission, the Council and the ECB have sent mixed messages as they wanted to assure the market that Greece would not default while at the same time telling Greece to solve the problem on its own. A rescue package involving German KfW buying Greek bonds is most likely ready to be implemented, but there is still a hope that Greece can handle this on its own. If Greece is rescued there is a moral hazard problem and the solution is probably closer fiscal monitoring and a more strict application of the rules. If on the other hand Greece is allowed to default contagion is likely. The EU will not let that happen.

Looking at the economic analysis the ECB still expects a very slow economic recovery and low inflationary pressure. Inflation in both 2010 and 2011 is projected to be well below the ECB's target. In addition, the monetary analysis is not sending any signals that the ECB needs to "lean against the wind" and hike rates.

The ECB announced at its March meeting that it will keep full allotment in place at its weekly main refinancing operations and at its one-month auctions until October. In this light we think that a hike in November 2010 is too early and we thus move our projection of a first hike to Q1 2011 (see Flash Comment Euroland: ECB will not hike before early 2011, 5 March 2010).

There will be headwinds from substantial fiscal tightening in most Euroland countries in 2011. We therefore expect that the ECB will hike the refinancing rate at a slow pace (by 0.25%-point every third month) bringing the refinancing rate to 2.0% at end 2011.

Danske Bank


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