Euroland: Making Sense of Mixed Signals -- Forecast Change
morganstanley.com
Eric Chaney on behalf of the European Economics Team
We cut our Euroland GDP growth forecast for 2004 For several months, our GDP growth call for Euroland has been above consensus. We think it is now time to reconsider the dynamics of the business cycle and, mainly because recent data have been disappointing, to remove the premium. We do not think that GDP growth will reach its potential this year, even less bridge the large output gap accumulated in 2002 and 2003. We are cutting our real GDP growth forecast for 2004 from 2.0% to 1.6%, on a calendar-adjusted basis. It is generally assumed that the combined effect of the leap year and of several public holidays taking place over weekends may add 0.2 to 0.3 percentage point to GDOP growth. Hence, on a non-calendar adjusted basis, we are cutting our forecast from 2.2% to 1.8%.
Q4 was weak, Q1 is still uncertain Our previous forecast assumed a significant acceleration of growth in Q4 2003 and above trend growth in Q1 2004. Only then had we priced in a slowdown due to the strength of the currency. However, Q4 results, 0.3% (quarterly, non-annualized) for the zone as a whole did not live up to our 0.7% expectations. In addition, prospects for the first quarter are still uncertain, although our early GDP indicator is marking 0.7%. Our country economists are depicting a gloomy picture, in Italy and Germany in particular. On the supply side, the main uncertainty remains the strength of the inventory cycle, which should have already kicked off. More fundamentally, on the demand side, the main source of uncertainty is the consumer sector. Consumer sentiment is very low and even though this does not necessarily imply low spending growth, as the French counter-example shows, we are unlikely to witness a sharp rebound in Q1. All that said, we continue to believe in the recovery scenario.
Capex, then, hopefully consumer spending Fragile and controversial as they may be, fourth quarter GDP data are showing an acceleration of domestic demand, mainly driven by corporate spending. Fixed investment increased 3.5% (quarterly annualized rate) while inventories added another 1.5 percentage point. In our view, all stars but one are aligned for a strong recovery of capital expenditure: global demand has accelerated, mainly from Asia and the US; real interest rates are historically low, even for manufacturing companies that live in slight deflation, and the stock of capital is rapidly aging. We believe that the increasing share of ICT equipment has reduced the lifetime of capital and that this has contributed to spark the global capex cycle, after almost three years of recession. In Europe, the missing star is the currency: the strong euro will limit the capex cycle because of its negative impact on profits. However, the clear message we are receiving from corporate Europe, via official business surveys or by means of our own analyst survey, is that capex plans are being revised upward, not trimmed.
Consumer spending: 1.4% growth is not audacious The most controversial part of our call is the consumer sector. Q4 consumer spending was flat, because of an outright contraction in Germany. Over the last two years, consumer spending has shrunk 1.1% in Germany, where a decline was reported every two quarters. However, we persist, maybe stubbornly, in believing that income tax cuts and lower prices will fuel spending, as they have always done, independently from consumer sentiment. More generally, we do not see as particularly audacious our revised consumer spending forecast (1.4% vs. 1.8% previously), given that last year, despite a quasi stagnation of GDP (0.4%), consumer spending nevertheless grew 1.2%.
Lower inflation, but retailers could do better We are also lowering our inflation forecast, despite several government-sponsored price increases such as hospital fees in Germany and tobacco prices in France. Stripping out the impact of administrative-driven prices, inflation would already be close to 1.5% and would probably drop close to 1% in the coming months. We are deliberately taking a cautious stance on inflation and now see the average increase of the HICP at 1.9% this year and 1.6% next year. Risks are probably tilted on the downside: January data are suggesting that retailers have understood that a key drag to their business is the perception of abnormally high prices felt by a large majority of Euroland consumers. If prices of durable goods, especially imported ones, started to decline for real, then consumers would surprise on the upside and the pent-up demand accumulated in 2002 would eventually show up in macro data.
Asymmetric risks We are not yet there, and we consider the consumer sector as a source of upside risks. On the other hand, the capex cycle is very sensitive to two factors: the currency and trade frictions. Unfortunately, the upside risk from consumers is rational but still hypothetical whereas both currency volatility and trade frictions are already a reality.
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Euroland: A Rate Cut in the Offing?
morganstanley.com
[another call for a HIKE from this guy - mish]
Joachim Fels & Elga Bartsch (London)
Lower rates for longer, but no cut
Disappointing fourth-quarter GDP data, the drop in several national February business confidence indicators and a slightly larger-than-expected easing of consumer price inflation in the first two months of the year have all rekindled market expectations of an ECB rate cut as early as this coming Thursday. In our view, however, the ECB remains reluctant to cut rates due to the accumulated excess liquidity, and we continue to believe that the next move in the refi rate will be up rather than down. However, with the economic recovery proceeding much slower than anticipated in recent months, we now think the ECB will be on hold for most of this year and will start to nudge rates higher only in the final quarter of this year. This also implies that the rise in bond yields that we foresee this year will me much more muted than previously thought.
What went wrong?
Our previous call that the ECB would start to hike rates from the second quarter of this year was based on three premises (see EuroTower Insights: Heading for the Exit, December 2, 2003). First, we were expecting euro area GDP to grow at an above-trend rate both in Q4 and in Q1, which would have likely induced the ECB to revise up its own GDP projections for this year and thus probably also its inflation forecast. Second, we expected inflation to remain relatively sticky near-term. And third, we thought that excess liquidity growth, together with sticky inflation and above-trend GDP growth would likely raise inflation expectations, eventually prompting a reaction from the ECB. While liquidity remains abundant despite some recent slowing in M3 growth, neither the first nor the second premise has held. First, real GDP growth in Q4 turned out to be only half as high as we had been forecasting. Thus, with a much lower entry level into the new year, our full-year 2004 GDP growth forecast has been cut from 2% to 1.6% (see E. Chaney, Forecast Change: Making Sense of Mixed Signals, March 1, 2004). Second, inflation has eased by more than expected to 1.6%Y in February according to the preliminary estimate. Against this backdrop, it is difficult to envisage the ECB moving into rate-hike mode anytime soon.
Why we don’t see a rate cut on the horizon
Hopes for an ECB rate cut are likely to be disappointed, in our view, for four reasons. First, according to (unconfirmed) press reports, the ECB staff has made only marginal downward adjustments to its (internal) GDP and inflation projections. Compared to the December staff projections, the mid-point of the 2004 GDP projection for this year has come down by a tenth to 1.5% while the 2005 forecast was left unchanged at 2.4%. More importantly, the inflation projection was cut by 0.1 percentage points in both 2004 and 2005, to 1.7% and 1.5%, respectively. These revisions, if endorsed by the ECB Council next week, would simply be too small to warrant a rate cut. Second, the ECB Council’s interest rate deliberations are not only based on the staff’s GDP and inflation projections but also take into account the monetary environment. Here, liquidity remains abundant and we continue to believe that the ECB will want to prevent pumping up asset bubbles via the provision of additional excess liquidity, which would go along with a rate cut. Third, we agree with our currency team’s view that the euro has probably peaked against the US dollar and we continue to emphasize that if the euro should rally further, the ECB is likely to react with FX intervention rather than a rate cut.
Fourth, recent calls by several European politicians, notably the German Chancellor, Gerhard Schroeder, and the French Prime Minister, Jean Pierre Raffarin, have made it difficult, if not impossible for the ECB to cut interest rates at the upcoming meeting without being seen as caving in to political pressures. Taken together, while we would not be surprised to hear from ECB President Trichet in the press conference next week that the Council had a debate on the merits of a rate cut, we expect the ECB to keep rates on hold at the March meeting and also for most of the rest of the year.
What would it take for the ECB to cut rates?
With the debate within in the ECB Council likely to be finely balanced, we assess below what it would take for the ECB to abandon its wait-and-see strategy and cut rates again. As discussed earlier, the downward revisions to our own forecasts as well as the reduction in the ECB staff projections reported in the press are not sufficient to warrant lower interest rates, in our view. But clearly any additional worsening in the outlook would make this call an even closer one. We have therefore identified several trigger points for a potential change in the ECB’s policy stance. Surprisingly, inflation is not one of them despite the slightly lower than expected reading over the first two months of this year. This is because inflation is driven lower by several one-off factors, many off which are likely to reverse in the coming months. In addition, we continue to believe that it’s the inflation outlook, not coincident inflation that matters.
EUR/USD at 1.35 and interventions unsuccessful
Starting with the obvious, the currency, it is important to note that new ECB staff projections are likely based on an exchange assumption of 1.25 or so for EUR/USD. While the currency is trading lower at the time of the writing, the recent EUR depreciation could potentially reverse. Mind you that’s not the official call of our currency team, who see EUR/USD gravitating towards 1.23 by year-end. But EUR/USD at 1.35 would likely warrant significant downward revisions to inflation and growth forecasts alike. Using the ECB’s own macro model and assuming that the 8% appreciation against the USD would fully translate into a rise in the trade-weighted exchange rate, such an exchange appreciation would reduce HICP inflation by half a point in the first year and another half point in the following year. Thus 2005 inflation, currently forecast at 1.5% by the ECB staff, would risk falling below the 1% deflation threshold. Similarly, growth forecasts would probably have to be pared by a quarter point for the first year and another half point for the following year. It would clearly take a lot more than 25 bp of easing to stem these downside risks. However, as we have highlighted before, the ECB would likely intervene directly in FX markets — verbally and actually — before cutting rate again (see EuroTower Insights: The ECB’s Dilemma, January 2, 2003). Only if interventions alone weren’t able to stem the upward pressure on the EUR, the ECB would be willing to lower rates in response, we think. But for now it seems that its verbal intervention over the last few weeks is paying off.
Consumer spending might disappoint further
More likely to trigger another rate cut than an overshoot in the exchange rate is a potential disappointment in Euroland’s domestic demand recovery. Contrary to business investment, which seems to be on the mend, consumer spending has broadly stalled since last spring. Even if consumer spending expanded gradually at a quarterly annualized rate of 1% in the remainder of this year, this would leave us with annual average of less than that, potentially reducing our GDP forecast by three-tenths. Based on historical correlations, a five-point drop in consumer confidence would probably hint at downside risks of this magnitude. In other words, the EU Commission’s consumer confidence indicator needed to plunge back to its low of -21 seen last March. Alternatively, and this is probably a more concrete risk, consumers’ inflation perception could stay at its present elevated levels. Euroland consumers continue to believe that euro area inflation is hovering around 5%, compared to the official data that shows it below 2%. If contrary to our expectations, inflation perceptions don’t start to gravitate towards reality soon, consumers’ would likely keep a close grip on their purses, raise their savings rate further and none of the pent-up demand that has been built over the last few years would materialize.
Corporate spending to weaken?
According to the national GDP data released thus far, business investment recovered gradually in late 2003. Feeding our capex indicator with the latest German capital goods orders, the US ISM survey and recent equity market moves suggests that capex picked up in early 2004 to an annualized 5% growth rate (see E. Bartsch European Economics: Taking a Closer Look at the Capex Cycle, July 9, 2003). For our indicator to signal stagnating capex in the second quarter of this year we would either need to see a non-annualized 5%Q drop in German domestic capital goods orders or the US ISM survey falling to around 55. Neither the correction in German December capital goods orders, which put Q1 order demand on a 1.5%Q negative ramp, nor the correction our colleagues are forecasting for the February US ISM survey are sending a strong enough signal. The same holds true for the latest round of business surveys out of the euro area. Despite the correction in headline business sentiment, our indicator for manufacturing production growth remained unchanged at a non-annualized 1.0%Q for the first three months of this year. With both output plans and actual output above their long-term averages in the manufacturing sector, the data are still consistent with above trend growth. In order for the ECB to get concerned, it would likely take a more pronounced re-rating of business sentiment, with the Pan-German Ifo business climate piercing through its long-term average of 94.3 to a reading of, say, 93.0.
A caveat
Note that we discuss these potential trigger points under a ceteris paribus assumption, i.e. we assume that everything else is unchanged. In reality, of course, there are many moving parts. Therefore, the critical levels for the various indicators that we have determined are probably at the lower end of what the ECB would likely be prepared to tolerate. In addition, these critical levels have been determined using our own quant tools for a rough-and-ready scenario analysis. The ECB staff use different econometric models and might hence not adjust their forecasts the same way we would. We would therefore take these potential threshold levels with more than a decent pinch of salt and would suggest you do th |
