Against the tide: Glow of recovery in Europe
At times the ECB seems to lurk so far behind the curve that it appears to be using some sort of random monetary-policy generator.
The tortuous Greek saga rolls on, the European Central Bank launches a full programme of purchases of eurozone sovereign debt and the Federal Reserve Bank continues to prepare to hike the US policy rate for the first time in 10 years. No wonder the euro has slumped in value towards parity with the dollar.
But behind these headline-grabbing events, there are finally signs that the eurozone economy is recovering. It has gone from flirting with recession to respectable growth in the last two quarters and the picture is continuing to improve. As I outlined in my last column, there has been improved credit transmission by the banks and increased purchasing power from lower oil prices. And corporate competitiveness and earnings will continue to be boosted by the twin forces of falling input prices and a weaker euro.
M3 growth has accelerated sharply since last spring and is now within touching distance of the 4.5% year-on-year level that the ECB regards as consistent with its price stability mandate. In real terms we are already at this level, which is finally shrinking the money gap (that’s to say the level of current M3 compared to where it would be, based on pre-crisis rates of monetary growth).
Monthly household and non-financial corporate credit flows have turned positive. This corroborates the pick-up seen in the new lending numbers and suggests that the upswing in the credit cycle is more developed than is appreciated. There remains concern that Basel III regulations have compromised the banking sector’s business model. This erodes the profitability of traditional bank lending by altering leverage rules and thus acts as a further catalyst for balance sheet deleveraging. But for the moment, falling interest rates seem to be sufficient to drive a recovery in credit and, with it, GDP growth.
The eurozone economy is best-placed to benefit from the decline in commodity (specifically oil) prices over the past six months. Although fixed per litre fuel tax rates are high, falling oil prices still feed into consumer incomes and confidence. They also improve corporate profitability and this coincides with the depreciation of the currency, which is a further boon to activity.
And at last, eurozone employment is rising, even if unemployment is not shrinking (with the exception of Germany). The feeling of improved job security that a steadier economy brings is encouraging consumers to spend. This can be clearly seen in retail sales, specifically core sales, which strip out the effects of falling oil and food costs. Although weakness in industrial activity has been more prolonged, there are signs of an upswing here too, with the business activity index moving to a seven-month high.
German real GDP growth looks particularly well-placed. And surprisingly, the story in Italy is similar. Excluding inventories, it appears that Italy’s recession ended in the second quarter of 2014, whereas the headline numbers show the economy is still shrinking. In France, real GDP has risen also, cushioning the impact of economic mismanagement and the more limited pass-through from the energy dividend, due to France’s nuclear energy supply.
And turbo-charging all this will be the formal start of the ECB’s quantitative easing (QE) programme. At times the ECB seems to lurk so far behind the curve that it appears to be using some sort of random monetary-policy generator. But the fact is the economy has found a base to bounce from, which the timing of QE complements perfectly. So rather by luck than by judgement, ECB president Mario Draghi may well be able to bask in the glow of an increasingly self-sustaining recovery. This is a particularly virtuous backdrop for eurozone equity markets.
Indeed, such is the momentum building for output, credit and consumer spending growth, even a collapse in the four-month extension agreement for the Greek bailout package will not throw the eurozone economy off course, although it could send the euro to new historical lows against the dollar.
The Greek economy represents no more than 3% of combined eurozone GDP and, although Greece grabs the headlines, it will create little headwind against the eurozone economic recovery. More important is any sign that the hiking of interest rates by the Fed in the US would have spillover effects on global equity and bond markets and on economic growth in the leading emerging markets.
Don't miss this month's cover story:
If Europe’s economy remains in crisis, then someone please tell the bond markets. The ECB’s asset purchase programme has driven half of the EU’s sovereign debt pile into negative yield territory. And central bank president Mario Draghi’s plan has only just started. Funds see little choice but to follow the QE monster on its path of destruction through the yield curve. Will that lead to the surreal outcome of all EU sovereigns yielding the same, regardless of credit quality?