Eurozone: We revise up our 4Q GDP forecast

• The November PMIs for the eurozone surprised to the upside, showing an unexpected acceleration in manufacturing and services activity. Strong readings in Germany and France suggest that these two countries are responsible for almost all of the improvement at the area-wide level.
• In view of this evidence, we revised up our 4Q 2010 GDP forecast for the eurozone to 0.4% qoq from the previous 0.2%-0.3% qoq. The yearly GDP average increases by 0.1pp both in 2010 (to 1.7%) and 2011 (1.4%).
• These revisions show that debt woes in the periphery are not having any meaningful impact on area-wide growth prospects, due to improving domestic demand fundamentals and still favorable financial market conditions.
• These growth developments should persuade the ECB that the exit strategy can continue at the 2 December meeting.

Unexpected PMI strength in November
Eurozone PMIs in November were much stronger than expected, flagging a solid re-acceleration both in factory and services activity vs. our and consensus forecasts of a further moderate easing. In particular, the manufacturing index rose to 55.5 from 54.6, with the production index up to 55.9 vs. 54.7 and new orders rising to 56.0 vs. 55.0. The new ordersstock ratio – a good leading indicator of future PMI moves – remained at 1.17, suggesting no large swings in the manufacturing PMI in the near term. The employment index rose further to 52.8 from 52.2, reaching the highest level since mid-2007. The services PMI moved to 55.2 from 53.3, with the outstanding business index rising to 49.9 vs. 48.8.

Employment was up strongly to 53.1 vs. 50.5, while business expectations moved sideways to 65.7 vs. 65.5.
At the country level, both Germany and France performed strongly. In Germany, the factory index surged to 58.9 vs. 56.6, and the services counterpart climbed to 58.6 vs. 56.0.

In France, the factory PMI rose to 57.5 vs. 55.2, while services improved to 55.7 vs. 54.8. The strong readings in Germany and France suggest that these two countries are responsible for almost all the PMI improvement at the areawide level. In other words, the core-periphery decoupling continues unabated.

Our composite PMI for the eurozone was back on the rise and climbed to 55.3 vs. 53.6, leaving the October-November level consistent with 0.5% qoq GDP growth. Given this evidence, we decided to raise our 4Q GDP forecast from 0.2-0.3% qoq to 0.4% qoq. With no hard data yet available, risks to our new call seem skewed towards a firmer reading.

Recovery unfolds despite debt woes
November PMI data clearly suggest that debt woes in the periphery are not having any material impact yet on growth prospects at the area-wide level. We see two main reasons for that:

1. Area-wide, investment and consumption fundamentals continue to recover, as shown by the fact that corporates’ financing gap position and labor market/consumer confidence indicators keep moving in the right direction.
2. Financial tensions in Ireland and Portugal have not led to any meaningful deterioration of overall financial market conditions. Apart from recent trading sessions, developments in equity prices, corporate spreads and volatility remain supportive for GDP growth. And when risk aversion rises, the euro works as an automatic stabilizer and tends to weaken, leaving activity somewhat insulated from financial shocks.

On 2 December, the ECB will probably decide to raise its 2010 GDP forecast from 1.6% to 1.7% and confirm the 2011 call at 1.4%, despite a stronger currency than in September.
The central bank is still on track for a first refi rate hike at end-2011, but if these PMI numbers were to persist, the ECB could even be forced to move sooner, although they may want to continue retaining full allotment (maybe at weekly operations only) to provide a safety net against debt woes.
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