Euro Zone: Taking A Walk on the Bright Side

Tullia Bucco and Davide Stroppa, UniCredit Group, Milan.
This article appeared in the June 2009 issue of Current Economics with permission of the author.

Key Concepts: Recession | Stabilisation | Recovery |
Key Economies: Euro zone |

Eurostat recently confirmed that eurozone GDP contracted at an unprecedented 2.5% quarter-on-quarter (q-o-q) pace in the first quarter of 2009, with fourth quarter 2008 GDP revised down by 0.2 percentage points (pp) to -1.8%. Quite in line with expectations, the expenditure breakdown displayed record drops in all components: in particular, fixed investment and exports collapsed (-4.2% and -8.1% q-o-q, respectively), and the contraction in private consumption deepened further (-0.5% vs. -0.4% q-o-q in the fourth quarter). With 2009 bound to mark the largest yearly GDP contraction on record (we expect –4.5% y-o-y), all eyes are now squarely focused on 2010, which will set the tone of the recovery. To this extent, we are slightly more optimistic than the European Central Bank (ECB), as we see nearly flat growth next year (0.1%), while the ECB staff forecasts a 0.3% y-o-y contraction, with a return to positive quarterly growth only in the second quarter of 2010.

Such a gloomy outlook for next year seems quite at odds with recent evidence about an improvement in some economic activity indicators. However, while we clearly welcome these first “green shoots”, we rather keep a cautious stance, and avoid reading too much into the first signs of stabilization: after all, the most acute phase of activity contraction is usually followed by a decline in the rate of deterioration. Still, we also acknowledge that at this juncture it is relatively easy to be on the pessimistic side, so we decided to raise the stakes and take a more challenging view, investigating what could go “right” for the eurozone economy, i.e. which are the upside risks to our central scenario. Our framework is very simple and is based on the standard path for a cyclical recovery, with inventory depletion as the first necessary step to realign demand and supply conditions, followed by an improvement in global trade, investment and eventually employment and consumption.

Let’s start with the inventories’ realignment in the industrial sector. The plunge in manufacturing activity over the last six months has been largely the result of a huge inventory adjustment process. Destocking subtracted 1.0 pp from quarterly first quarter 2009 GDP growth, marking the largest negative inventory contribution since the GDP series inception. Clearly, with unsold goods piling up and financing hard to come by, firms have slashed production even faster than the sudden and unexpected fall in global demand. The result has been the most classic version of a textbook “inventory-led” recession. Given the key role of the imbalance between supply and demand in the industrial sector, it is crucial to rely on a timely indicator: our preferred gauge is the New Orders to Inventories ratio (NO/I ratio henceforth), constructed using the new orders and the stocks of finished goods components from the manufacturing PMI. The NO/I ratio, which leads quite well the headline PMI, fell to an all-time low of 0.522 in December 2008, but has rebounded since then and in May stood at 1.041, the highest since end-2007, when the PMI was above 50 and industrial output was still expanding.

Only a moderate recovery ahead NO/I ration sends encouraging signs
Moderate recovery expected for the Eurozone New orders to inventory ratio
Source: Eurostat, Markit, UniCredit Research Source: Eurostat, Markit, UniCredit Research

This is encouraging for the growth outlook because it would imply that the industrial recession may be over much sooner than generally expected. Should firms decide to realign production to demand conditions, inventory rebuilding could lead to some upside risks in the near term. However, only a genuine pick up in demand strong enough to generate a recovery in business confidence and therefore investment plans could induce a sustainable swing back in the industrial production cycle.

In this respect, signals coming from business surveys are surely encouraging, as they go in the right direction: in May, the manufacturing PMI rose to 40.7 from 36.8, marking the largest one-month gain on record, while the increase in the services sector was more moderate (44.8 vs. 43.8). Consequently, our Composite PMI moved up further to 43.9: taken at face value, this would imply a 0.6% q-o-q contraction in the second quarter, a substantial improvement from the -2.5% recorded in the first quarter. We stress that while in the last few quarters the Composite PMI has substantially underestimated the pace of recession, we are relatively confident that as the cycle normalizes, this bias will tend to disappear. In this environment, a more solid recovery in business confidence needs to be accompanied by a prompt recovery in external trade. This is in line with what we concluded three months ago, when we extensively argued that the recovery path for the eurozone depended in large part on the materialization of signs of a recovery in global trade. Indeed, over the recent months, the most convincing signs of stabilization came from Asian countries, many of which are large exporters: in China, the PMI index remained above the 50-threshold for the second consecutive month, while Fixed Assets Investments resumed a healthy growth. Moreover, other important exporters like Taiwan, Singapore and Korea showed signs of improvement in output-related data for April. A third welcome sign came from the Baltic Dry freight index (BDI), which measures freight and shipment costs for commodities, and is usually a rough proxy for global trade. Since the beginning of the year, the BDI has risen four-fold, although it remains some 60% lower than the highest level reached last July, at the top of the commodity bubble. Given that in 2007 and 2008 the BDI was probably inflated by speculative traffic rather than by real trade, the smaller role played by financial speculation in the current juncture makes the recent increase all the more impressive and bodes well for a genuine recovery in world trade in coming quarters.


Business confidence is rebounding Signals of reviving global trade
Business confidence is rebounding Global trade reviving
Source: Markit, Bloomberg, UniCredit Research Source: Markit, Bloomberg, UniCredit Research

Assuming that all these conditions materialize, so that a genuine pick in global demand spurs expectations of a swift recovery in economic activity and thereby generates positive spillovers to industrial production, it would then be realistic to expect that firms will revise up their investment plans. The upshot would be that investment could resume growing before end-2010, as we currently foresee in our baseline scenario.

Still, for upside risks to materialize on our capex outlook, substantial improvements must be fully observed in banks’ ability to lend. The most recent European Central Bank (ECB) data show that the credit slowdown continues unabated: in April, lending to non-financial corporations (NFCs) eased further to 5.2% y-o-y vs. 6.3%, well off the peak (14.9%) reached in April 2008. Looking ahead, the outlook remains rather mixed, both on the price and the quantity side. As for the former, encouraging signs come from money markets, which have experienced significant improvement, as risk appetite and confidence in the financial sector have increased, thanks to public support measures. Thus, short-term rates have kept declining: the 3-month Euribor rate has fallen some 400 basis points (bp) since its peak in October 2008. Evidence that such a decline is translating into lower lending rates has finally begun to appear: a weighted measure of short-term rates for NFCs now stands at 3.00%, down 266 bp from the October peak, while longer-term rates stand at 3.87%, 180 bp down the peak. While such declines have not yet matched the size of the drop in the interbank rates, this evidence is surely encouraging. As regards the outlook for the quantity of credit, indications are less upbeat. The latest ECB Lending Survey shows that credit standards are stabilizing somewhat but around very tight levels: in the first quarter of 2009, the net percentage of banks reporting a tightening of credit standards for loans to enterprises declined to 43% vs. 64% in the fourth quarter of 2008.


Cheaper borrowing costs
Lending interest rates on new business for NFCs
Eurozone banks' cost of funding
Funding costs defined as 5Y Bund yield + spread iTraxx Financial
Cheaper borrowing costs Cost of funding in the Eurozone
Source: ECB, Bloomberg, UniCredit Research Source: ECB, Bloomberg, UniCredit Research

Though off the peak, this level signals a significant degree of additional net tightening of already tight credit standards. Going ahead, banks’ funding costs will play a crucial role in the ability of banks to pass on lower interbank rates to final customers. Indeed, the BLS showed that while banks’ cost of funding and balance sheet constraints exerted a smaller influence on their decisions about credit standards, they still play an important role. In order to assess the extent to which refinancing costs could ease, we have proxied a measure of banks’ funding costs via the sum of the iTraxx5Y spread on Senior Financials and the 5-year yield on the German Bund. The chart above shows that this measure declined steadily from mid-2008 until January this year, but this was driven only by the sharp decline in bond yields, while the spread on Financials kept increasing. After a temporary surge in January-March, funding costs resumed declining over the past two months; this time, however, the decline occurred despite a steady increase in bond yields, as the spread on Financials more than halved. This evidence is reassuring and supports the view that in the relatively optimistic scenario we have in mind, banks’ ability to lend should not pose any major hurdle to a recovery in capex growth.

Moreover, we see an additional supportive element for an easing in bank funding costs: governments’ measures of financial support to the banking system could become more and more effective in reviving inter-bank lending and eventually triggering an improvement in credit standards.

In this respect, we find indicative the experience of the French financial sector, which benefited from timelier and more decisive government support. According to the latest Banque de France’s quarterly lending survey for the first quarter, the net percentage of banks reporting a tightening of credit standards halved (to 23% from 41%) in the case of loans to enterprises, and approached zero for loans to households. It may not be a fluky coincidence that more than half of the participating banks reported that government support measures helped (albeit moderately) to improve their access to market refinancing and an even (slightly) larger percentage expect that this will also be the case in the second quarter.


Unemployment skyrockets...
Unemployment change (000s); unemployment rate (% labor force)
...As firms frontloaded job cuts
Regression of eurozone employment on lagged GDP
Rising unemployment in the Eurozone Job cuts in the Eurozone
Source: Eurostat, UniCredit Research Source: Eurostat, UniCredit Research

Assuming all things “go right” up to this point, employment behavior could also represent a source of potential upside. The quicker response of employment to the decline in GDP growth since the beginning of the recession, and particularly after the Lehman collapse, suggests that hiring during the early stage of the recovery could possibly pick up more quickly than could be envisaged on the basis of the usual relationship GDP/employment. Simple econometric analysis suggests that, on average, it takes two-to-three quarters for employment to adjust to developments in economic activity. However, as can be seen the residuals of the regression in the chart below, this relationship has displayed something that looks like a structural break since the third quarter of 2008. A more prompt response of employment to activity possibly reflects the fact that by mid-2008 there was little doubt left about the nature of the slowdown and this strengthened firms’ resolution about firing excess labor. It is also probably related to the high degree of utilization of temporary workers which is typical of the economic sectors most heavily hit during the downturn, namely construction, where employment fell by 2.4% in 2008 from +3.9% in 2007. Overall, evidence of frontloaded job shedding during the recession bears one important implication: in a scenario that assumes a sizeable recovery in industrial production amidst increasing confidence about a genuine recovery in demand, firms could resume hiring well before late 2010-early-2011, as we have penciled in our baseline. In turn, this could have a meaningful spillover on consumption and could eventually fuel a virtuous cycle of self-sustaining demand.

Bottom Line: Tentative signs of a pick up in global demand along with evidence that the inventory cycle has turned have spurred an improvement in business confidence of late. This bodes well for a near-term pick up in economic activity as long as firms step up production to meet increasing demand. But the real issue at stake is whether the increase in demand is sustainable and could make the green shoots grow and flourish. Hopes for the recovery to become entrenched sooner than expected rely on the materialization of upside risks that can be easily identified with respect to each growth component, with exports likely to be the main trigger. Our baseline scenario remains cautious, but we acknowledge that talking about upside risks on the growth outlook makes sense for the first time in many months.

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