Q2 Outlook: A reality check for the euro area
Summary: The problems facing the Eurozone economy are neatly illustrated by fresh German data showing soft exports and contracting factory orders. While Chinese fiscal stimulus should help get Europe’s biggest economy back on track, expansionary fiscal policy across the bloc, as well as interest rate normalisation, are also necessary to ameliorate the ills of the euro area as a whole.
At the same time, large declines in core European industrial production data can be observed, especially in Germany, which accounts for one-third of European industrial activity. This slowdown came as a shock for many policymakers, but we feel that it was predictable. Over recent quarters, our leading indicators (notably credit impulse) led us to warn clients and investors against the risk of lower growth in Europe.
Low credit impulse and China
The euro area faces two main issues: low credit impulse and the Chinese slowdown. The euro area credit impulse, a key driver of economic activity, is running at 0.4% of GDP, which is rather low compared with its four-year average of 0.8%. A country-by-country analysis shows that the risk of growth decoupling between core countries and the periphery of the euro area is emerging again. In France and Germany, credit impulse is positive, at 1.7% and 0.6% of GDP respectively. By contrast, the credit impulse is sharply decelerating in the periphery; it was close to zero in Q4‘18 in Italy and sits at -2.1% of GDP in Spain, a level not seen since the end of 2013.
This tends to indicate that a more restrictive credit cycle, especially in the periphery, has started. This will have a negative impact on domestic demand as it is highly correlated to the flow of new credit in the economy, and ultimately on growth as well.
Monetary policy options
As it is so often the case, all eyes are on the European Central Bank. In a bid to win time and avoid a tightening squeeze hitting Eurozone banks, March saw the ECB announce a new round of TLTRO and a modification of forward guidance to extend its first rate hike into 2020. In our view, this is only a first step towards a more accommodative stance. As of today, discussions among ECB watchers are notably evolving around the idea of pushing the repo rate back to zero. The rationale behind this idea is that the benefit of negative rates is rather low; they are essentially a tax on banks that tends to further enfeeble the weakest banks. So far, the positive impact has been limited and has strongly depended on the structure of banks. The normalisation of the repo rate would be an easy move to reduce pressure on the banking sector if the risk of a tightening squeeze appears again.
Fiscal push in H2'19
1: SEE BEETSMA, R., GIULIODORI, M. AND KLAASSEN, F., “TRADE SPILL-OVERS OF FISCAL POLICY IN THE EUROPEAN UNION: A PANEL ANALYSIS”, ECONOMIC POLICY, VOL . 21, ISSUE 48, 2006, PP . 640–687