EMU: Euro strength – a risk factor, not a swing factor

EMU: Euro strength – a risk factor, not a swing factor

• Despite recent euro strength, we are not keen to revise down our 2011 GDP forecast for the eurozone, currentlyat 1.3%.
• Business surveys indicate some upside risks to our GDP projections at end-2010, and a stronger-than-expected entry into next year is a distinct possibility.
• Euro appreciation is mostly the result of QE2 talk, which led to a generalized increase in equity prices and a drop in volatility and corporate bond spreads. This will probably suffice to neutralize some of the damaging growth impact of a stronger euro.

Substantial GDP deceleration in 3Q, 
but the recovery continues

After sustained economic growth in the first half of the year, eurozone GDP entered a decelerating trend in 2H, facing headwinds from slower global growth, a fading boost from the inventory cycle and the beginning of fiscal consolidation in peripheral countries. All these negative elements were already included in our GDP forecasts, and are therefore unlikely to change the growth picture we have in mind: we continue to think that the recovery remains on track, with a limited risk of a double-dip recession. However, the recent euro appreciation has emerged as a new source of downside risks to our 1.3% GDP forecast for 2011.

But let's take a closer look at 2H 2010. Hard data and survey indicators suggest that a clear loss of momentum in 3Q is in the cards after a stellar 2Q (cf. chart next column). But the deceleration should not be abrupt. Based on the hard data so far available, our GDP Tracker remains consistent with 0.4% qoq growth in 3Q (which is our official forecast) vs. 1.0% in 2Q.

Industrial production – the most relevant input of the Tracker –came to a complete halt between the end of 2Q and the beginning of 3Q, but re-accelerated strongly in August (1% mom), pushing the July-August industrial production level 0.9% higher than 2Q. Matching the same record pace of production growth recorded in 2Q is certainly out of reach, but the performance in the first two months of the third quarter should suffice to achieve an orderly slowdown in industrial production in 3Q, even assuming renewed weakness in September (which we deem as likely). This deceleration in industrial output largely reflects: 1. a clear slowdown in the pace of re-stocking, and 2. an easing in the export dynamic.

The export sub-index of the manufacturing PMI points to 2% qoq growth after the 4.3% recorded in 2Q, and trade balance data are broadly consistent with a similar performance.


Although showing signs of life, domestic demand seems unable to fully offset these two drags. On the one hand, improving but still weak fundamentals, together with slowing exports, should push machinery spending towards a more subdued growth path following the 2Q strong rebound (+2.9% qoq).

On the other hand, a stagnant employment dynamic is preventing any meaningful acceleration in household spending, although the savings rate has peaked and consumer confidence has risen back to its long-term average. The consumption leg of our GDP Tracker underpins the view of sluggish, albeit still positive, spending dynamic in 3Q: service sector confidence improved further and car registrations flattened out after a
very bad 1H, but retail sales growth remained moderate.

These are likely to remain the key trends also in 4Q. However, the October round of business surveys suggests that the economy may well have entered the final quarter of the year on a slightly stronger footing than we are currently projecting.

True, the composite PMI and the Economic Sentiment Indicator (ESI) have moved along diverging paths for several months – the former is trending lower while the latter is still improving – but we don’t see this as overly surprising given that the PMIs had risen more briskly from the cyclical lows than the ESI.

What matters is that the level of both surveys is consistent with GDP growth of around 0.5% qoq at the end of the third quarter, with the October pointing to a still healthy 0.4% qoq at the beginning of 4Q.

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Full Report: EMU: Euro strength – a risk factor, not a swing factor