Euroland: Pricing In the Announced Recovery
Anna Grimaldi & Eric Chaney (London)
Marking to market our 2003 GDP call
The latest data releases all tell the same story: Euro-area economies are still struggling, but the worst appears to be behind us. Back in July, Euroland manufacturers had reported a marked improvement in output plans, which is one of the first signals we look for as we near an upturn. But having had our fingers burned several times by jittery surveys and false starts, we were reluctant to upgrade our GDP forecast. Yet with further progress in the latest business surveys and hard data pointing to some improvement in economic activity, we now think the Euroland economy may have entered the recovery phase earlier than we had originally anticipated. Q4 GDP growth should also come in slightly stronger than we had previously forecasted, helped by the usual cyclical accelerating factors. Hence, on the back of stronger H203 growth, we are modestly upgrading our 2003 GDP growth forecast to 0.5%, from 0.4% previously. For the time being, we are leaving our 2004 forecast unchanged, although we acknowledge that risks are skewed to the upside. In this note, we look in more detail at the reasons underpinning our 2003 forecast revision and assess the risks to our 2004 growth call.
Company surveys point to an earlier recovery
The revision to our 2003 GDP growth forecast is largely based on information coming from Euroland manufacturers. The August industrial survey confirmed the improvement in output plans that was already apparent in July, while also showing a turnaround in the assessment on current conditions. This suggests that more optimistic expectations have started to materialise. Our manufacturing production indicator turned from negative to positive and is now estimating a rebound of 0.3%QoQ in Q3 output. Last but not least, the latest Eurostat release pointed to an increase in Euroland production of 0.6%MoM for July.
Most of the good news is for our 2H03 GDP forecast
Cumulatively, this evidence seems to favor an earlier recovery. Our GDP indicator shows a significant rebound in Q3 growth to 0.5%QoQ after a decline of 0.1%QoQ in Q2. Even so, we remain cautious and are only raising our Q3 GDP growth number from zero to +0.3%QoQ. Indeed, the September edition of the Morgan Stanley European Quarterly Analyst Survey suggests that while business conditions have improved, Euroland companies are still engaged in restructuring their cost base. While less gloomy than in June, capex plans were still downbeat, as were hiring intentions. Only in Q4 do we expect to finally see an acceleration in capex spending, which should bring GDP growth back to trend. Overall, we have only modestly revised our Q4 number from 1.6% in quarterly annualized terms to 1.8%QoQ.
So far no changes to our 2004 forecast but ...
Looking ahead, our view on the Euroland economy has not fundamentally changed. Indeed, for the time being, we have left our 2004 GDP growth forecast unchanged. We see GDP growing above trend in early 2004 (2.8%QoQ in quarterly annualized terms), but the momentum should then peter out from Q2 onwards, with growth returning to trend in H204. The acceleration in GDP growth at the start of the year should largely come from the capex and inventory cycle. Tax cuts worth 0.2% of GDP should help to boost private spending.
... We could be surprised on the upside
While we have left our 2004 forecast unchanged at 2.0%, we acknowledge that we could well witness an upside surprise. Indeed, the main surprise could come from consumers. Previously, we highlighted the fact that higher inflation perceptions linked to the introduction of euro notes and coins led to an increase in savings of ˆ88 billion. Yet as the gap between actual and perceived inflation closes, pent-up demand should be unleashed, helping to boost spending growth. In addition, although our colleagues are now calling for the end of the ECB easing cycle (see Joachim Fels & Elga Bartsch, "Inflation Scare in the Making" in today’s Forum), the monetary policy stance still remains fairly expansionary. Finally, with Euroland governments now more committed to delivering long-awaited structural reforms, we have sufficient reason to expect higher growth in 2004. But for the time being, we would rather wait for further evidence from the hard data before adjusting our forecast.
Euroland: Inflation Scare in the Making
Joachim Fels & Elga Bartsch (London)
Rate cuts no more
Four weeks ago, we still saw a greater-than-50% chance that the ECB would cut rates one last time in this cycle (EuroTower Insights: The End of the Easing Cycle? August 21, 2003). Today, we think the chances have dropped below the 50% threshold, and are pulling the plug on that forecast. We now expect the ECB to keep rates unchanged at 2% until around the middle of next year, before embarking on a moderate tightening of policy in the second half of 2003. There are three related reasons why we now think that rates have bottomed.
First, we are raising our near-term growth forecast
While the forward-looking components of the business surveys have been pointing to recovery for several months, the incoming hard data had been disappointing until recently. With industrial output rebounding in July and the assessment of current conditions in the business surveys also improving, we now see stronger economic growth in the remainder of this year, with GDP rising by a (non-annualised) 0.3% in the current quarter and by 0.5% in the fourth quarter (see E. Chaney and A. Grimaldi, “Pricing In the Announced Recovery,” in today’s Forum).
Second, upside risks to the 2004 outlook are building
We increasingly see upside risks to economic growth next year. While we haven’t raised our (above-consensus) forecast of 2.0% euro-area GDP growth in 2004, there is a distinct possibility of a stronger outcome. The reason is that the combination of an expansionary monetary policy -- as indicated by zero real interest rates and strong monetary growth -- and more decisive structural reforms, which are now in the pipeline in several countries (see J. Fels, European Economics: Reforming Europe, July 31, 2003), could easily lead to a surge in business and consumer confidence at some stage. Interestingly, this is what appears to have happened in Japan this year, where GDP growth and especially domestic demand have surprised on the upside. Throw in the significant amount of pent-up consumer demand that has built up in the euro area over the past two years, and we might be in for a major positive surprise in 2004.
Third, we are nudging up the 2004 inflation forecast …
With the euro now weaker than we assumed in our last forecast and with higher oil and food prices having kept headline inflation a touch above expectations recently, we have also nudged up the inflation profile for the remainder of this year and for 2004. We see inflation hovering around, possibly slightly below, 2% in the remainder of this year before easing to a trough of around 1.3% by March of next year (against 1.1% previously). Our forecast for 2004 annual average inflation has gone from 1.5% to 1.7%. Comments by ECB Vice President Papademos in the early-September press conference suggest that the ECB has also revised up its internal inflation forecast for next year to a similar level. Thus, with inflation projected to be in line with the norm of “below but close to 2%”, rate cuts are off the ECB’s agenda, for now.
Euro could still spoil the party
The main wild card in all of this remains the euro, in our view. A renewed sharp appreciation -- which is not our currency team’s main forecast but clearly a risk -- could still force the ECB to cut rates again or at least delay the beginning of the tightening cycle. Our macro forecasts are based on the assumption that the euro will trade only moderately above current levels during next year. However, a sharper appreciation back to and above US$1.20 in the next several months could easily derail the recovery and put rate cuts back on the ECB’s agenda. Things would be different, though, if the euro rallied at a time when the domestic recovery in the euro area is more firmly established. A stronger euro could then even lead to virtuous circle where the terms-of-trade improvement supports domestic consumer spending, which in turn could give additional support to the euro. For now, however, while domestic demand is only starting to recover, a sharply higher euro would be bad news for the euro economy.
An inflation scare in the making?
While we don’t expect inflation to rear its ugly head over the forecast horizon, we believe that there is a risk that, within the next 6 to 12 months, the bond market, peering beyond 2004, will become concerned about the longer-term inflation outlook. This could push ten-year bond yields well above their fair-value level of 4.5% in the first half of next year, we think. Since decisive monetary easing and a more vigorous US recovery have brought an end to the deflation debate, we fear that an inflation scare might take hold in financial markets, for several reasons.
Drowning in liquidity
First, over the last two years, substantial excess liquidity has accumulated in the euro area financial sector. At the end of the last quarter, the real money gap was running at a staggering 7.1%, the nominal money gap was even printing a higher 9.2%, thus potentially pointing to significant inflation pressures. True, euro-area monetary aggregates are substantially bloated by major portfolio shifts at the moment, as investors have pulled out of equity and bond markets and piled into money market funds and deposits. As the latter are included in the ECB’s definition of broad money supply, these shifts caused M3 growth to balloon. But if the portfolio shifts are not reversed once the euro economy starts to recover, the risk rises that at least part of that excess liquidity finds its way into higher prices for goods and services. Such persistent strong money growth, in our view, could also induce the ECB to embark on a more aggressive tightening campaign than the one that we presently forecast.
Too much debt
Second, like the other post-bubble economies around the world, also the euro area has seen a marked rise in private sector indebtedness since the mid 1990s. This legacy of past asset price inflation and the brave new world of low interest rates imply that today’s economies are likely to be more sensitive to interest rate changes than they were in the past. As private-sector balance sheets, both in the household and the corporate sector, remain very lop-sided as asset values imploded and liabilities stayed elevated, central banks are likely to tread very carefully, we think. Consequently, they are bound to err on the cautious side when it comes to tightening monetary policy (see J.Fels, European Economics: Too Much Debt, September 4, 2003). In our view, central banks will be willing to trade a higher inflation trajectory in the future for a lower risk of an unwanted further decline in inflation in the near term. Markets, however, might come to the conclusion that central banks are falling behind the curve, a concern that will not go unnoticed at the long end of the yield curve.
More lenient towards inflation
Third, as both the private and the public sector continue to pile up debt, a social consensus is likely to emerge that leans towards tolerating higher inflation. This leniency towards inflation likely also reflects a reaction to the past debate about the perils of deflation. A first step towards such greater inflation tolerance can be seen in the draft of the EU Constitution. This draft seems -- at least at the margin -- to give less prominence to price stability as the primary goal of monetary policy than the Maastricht Treaty by calling for “balanced” rather than “inflation-free” growth. The draft Constitution could also infringe on the ECB’s institutional independence compared to present arrangements by making it part of the regular body of European Union institutions. Not surprisingly, therefore, the ECB looks set to publish a critical statement on the draft of the EU Constitution this coming week, underlining that changes in the institutional setup could become a source of inflationary concerns.
Roller coaster ahead
With several reasons to expect higher inflation to take hold again over the longer term, the only thing the market needs to embrace an inflation scare is a small rise in the actual inflation rate. This could happen as early as next spring, on our forecasts. In that event we would expect another marked rise in bond yields into the upper part of the 4.5-5% range and a substantial yield curve steepening. Once the ECB starts to hike rates, however, the bond market might calm down again, and ten-year yields could grind lower, causing a major flattening of the yield curve. Hang on to your hats!
morganstanley.com |
