Euroland: Welcome to Stag-disinflation
morganstanley.com
Eric Chaney (Paris)
Not by coincidence, April business surveys and inflation data out of the euro area both surprised on the downside. Having the German, French, and Italian surveys in hand, I am struck by their similarities: not only did producers reveal a large mismatch between supply and demand, resulting in excessive inventories in the three countries, but the business community also has turned surprisingly negative on “economic conditions,” that is, on the broad economic and political environment. On the price front, a flash estimate for harmonized inflation came out at 2.1%, with country data suggesting that the final number might be significantly lower. With the benefit of hindsight, a 2% annual inflation reading after a 46% increase in oil prices over the same period, and a 380% increase over the last four years, is benign inflation, to say the least. A couple of years ago, I had warned that a combination of a strong currency and rigid labor markets would yield a poor macro result: very slow growth and very low inflation, a stag-disinflation. I am afraid that this is where the euro area has now landed and where it might stay there for a while.
That business surveys turned more negative was not a real surprise: since March, fundamentals had not improved – the euro is still largely overvalued; crude and, more importantly, refined petroleum products are close to all-time highs; and neither equity nor credit markets have been friendly to corporate Europe. However, there was no significant deterioration either. Hence, we had expected only a limited slip in business sentiment. Things turned much worse, however. The main indicators we trust, i.e., the assessments on current production, demand, inventories, and future production all went down. Over the last two months, the current production index dropped by 40 bp, a sign that companies have been scrambling to cut production. In January, the assessment on inventories was still consistent with relatively tight inventories. Four months later and after a 60 bp rise, it was pointing to a significant excess.
With the April business surveys in hand, our proprietary quantitative tools are now forecasting a 1.3% quarterly contraction in manufacturing production and a flat, maybe slightly negative, reading for GDP growth. Is this the beginning of the feared “triple dip”? At this stage, we have a view similar to that of our New York colleagues for the US: Europe was hit by the last leg of the rise in refined oil products, but the fundamentals, although not exciting, are not any worse than they were a few months ago. Monetary and financial conditions are quite friendly, credit to the private sector is rising faster than actual production, and, on a trade weighted basis, the euro is weakening. It is now almost 3% lower than it was at the end of last year. Since the European recovery has barely started, there is still a lot of pent-up demand, on both the consumer and corporate sides. For all these reasons, we continue to bet on a modest rebound, once the current adjustment in inventories is behind us.
However, we reckon that risks are on the downside. Another factor seems to bear on business sentiment, independently from traditional macro variables such as monetary conditions or input costs. The French and the Italian manufacturing surveys have revealed a sharp deterioration in “economic conditions” in both countries. This question is traditionally a barometer of how corporate Europe is judging its business environment, in opposition to company-specific business conditions. I suspect that the messy debate on the EU Treaty in France and the cabinet crisis in Italy are giving headaches to company managers: executives dislike political uncertainties that come on top of jitters in their own markets. The anti-business popular sentiment that is developing in Germany puts the largest Euroland economy in the same camp. As I see it, the risk is that corporate Europe could embrace a wait-and-see behavior; cut inventories, where the opportunity cost is rising; and postpone investment decisions to better days. In macro jargon, the risk is that the pessimism expressed by business leaders could become a self-fulfilling prophecy. In that case, our “soft patch” theory would prove wrong.
Even if our main-case scenario, i.e., a soft recovery in Q3, with GDP growth up to around 2% (annualized) in the second half of the year, turned out to be correct, the bigger picture in Europe would remain bleak in my view. Since the main reason for the weakness of the US dollar is the ever-widening current account deficit – in this regard, Q1 GDP imports as reported by US national income accounts were pretty discouraging – it is difficult to envisage any significant reflation coming from currency markets for the euro area. With real interest rates already at zero and fiscal policies more or less frozen, reflation is unlikely to come from policy makers. On the other hand, wage moderation has turned into wage deflation in several regions, starting with Germany, where this is a necessary but extremely painful adjustment. The conclusion: Europe is doomed to remain in this stag-disinflation world for a long period of time, the risk being that disinflation could turn into outright deflation if the risk scenario I alluded to earlier became a reality.
I am afraid that stag-disinflation is where the euro area has now landed and where it might stay for a while. |
