While financial markets have focused on signs of weakening global growth, driving Bund yields to extraordinary low levels and weakening stock markets, the growth statistics for the euro zone have been overwhelmingly positive. GDP growth in Q2'10 surpassed all expectations while the survey results for Jul-Aug'10 point to robust growth being pretty much sustained in Q3'10.


For Euroeconomics 2010-11 forecasts updated 3 Sep'10 see below.

Growth: robust in core-Europe, increasingly driven by domestic demand

The business surveys for Aug'10 indicate that activity remained at a high level, losing only a little momentum in spite of fears of a global growth slowdown. The advance is led by core-Europe with the most indebted peripheral countries failing to keep up.

There are more signs that the upswing in core-Europe is less reliant on exports. An improvement in consumer confidence may foreshadow gains in consumer spending. Global growth indicators, notably for the US, have recently been on the weak side, pointing to a slowdown in global growth.

(for full coverage of all euro zone surveys see surveys)

The "hard" statistics portray a surging recovery in industry in Q2'10. Though the industrial production statistics for Jun'10 indicated a pause, new orders have soared. Exports are on a steep uptrend.

Employment data have been unexpectedly positive. Overall employment stabilised in Q1'10 and the unemployment rate was stabile over the Mar-Jul'10 months, though at a still high 10.0%. The surveys suggest a slight rise in private sector employment in May-Aug'10. Retail sales are on a moderate uptrend.

Results for the construction sector, however, are still poor and  the trend in new car sales is sharply down.

GDP in  Q2'10 brought an unexpectedly steep gain of 1.0%, spearheaded by Germany. By sector growth came from fixed investment and consumer spending. Surveys suggest quite a strong start to Q3'10. But expectations among most forecasters are now that strength may not be fully maintained in subsequent months because of the faltering US economy.


 (for full coverage of all euro zone growth statistics see growth variables)


For Euroeconomics 2010-11 growth forecasts see below.

Financial variables: EU and ECB provide massive support to counter debt crisis

After the financial markets threatened to run out of control as the euro zone's sovereign debt crisis intensified,  the ECB 10 May'10 announced  wide ranging support measures for the euro zone financial system, including buying bonds and providing unlimited liquidity to the banking system.

The ECB has of late displayed  greater confidence that the debt crisis is under control and wishes to "normalise" monetary policy - i.e. move away from all out stimulation. But until end-2010 at least banks may still be able to borrow unlimited funds from the ECB at 1%.

The EU itself announced a "big number" EUR750bn financial rescue package, one third of which is to come from the IMF. Assistance is to be linked to measures to reduce budget deficits. It is hoped that this facility may not have to be used.

Fiscal policies are this year becoming  less expansionary. The south European countries have  been obliged to introduce fiscal restrictions. The rest of the euro zone is expected to follow in 2011.


(for full coverage of all euro zone financial indicators see financial variables)


For money market rate forecasts for 2010-11 see below.

Financial markets: recovering their poise after global growth fears abate

Financial markets in Aug'10 focused on the potential for a major slowdown in global growth after a long series of poor growth indicators from the US and a few indications that growth in China may also be moving down a gear. This boosted safe haven flows into USD and (massively) into government bonds at the expense of stock markets.

The first days of Sep'10 brought more positive news on growth, boosting stock markets and driving bond yields up from the extraordinary low levels reached end-Aug'10. The EUR similarly benefitted as safe haven flows into the USD ceased and the euro zone sovereign debt crisis faded after the measures taken by the ECB and the EU gained credibility.


(for fuller coverage of the main euro zone financial markets see  financial markets)


For stock and bond market forecasts for 2010-11 see below.


Sovereign debt crisis:  easing

The Greek debt crisis and its spreading to other deeply indebted euro zone countries focused attention on the increasingly divergent trends in the euro zone countries' current account balances, unit labour costs and employment. Speculation intensified about whether the euro zone's divergent member countries can sustain a monetary union.

Rather than an EMU break up, a change in its constitution may be the result of the crisis, allowing for bail-outs and introducing more effective constraints on the fiscal policies of member countries to cover the shortcomings of the Stability & Growth Pact.

Those that predict failure, a break up of the euro zone, one or other country leaving, fail to appreciate just how impossible an undertaking this would be in practice.

(for a thorough and detailed discussion of the obstacles facing a country leaving the monetary union see Eichengreen)


(for full coverage of  euro zone institutions and their shortcomings see constitution)


 

New members euro adoption prospects: Estonia to become 17th member 1 Jan'11

The latest Convergence Report by the European Commission was published 12 May'10. It gave the green light for Estonia adopting the euro on 1 Jan'11. After the problems with Greece the entry criteria are now more harshly scrutinised. Also doubts about the benefits of euro adoption have multiplied among the candidate countries.

The table below indicates the earliest year in which other countries may adopt the euro. Entry usually takes place at start of year. (more at members)  Many commentators, mostly in the UK and the US, believe that membership of the euro zone is more likely to shrink than expand. (more at constitution)

 

      News:

• Estonia received the final go-ahead for adopting the euro on 1 Jan'11 when the EU finance ministers approved  13 Jul'10 the conversion rate of 15.6466 Estonian Kroon (EEK) to the EUR. The Kroon has been pegged to the EUR at this rate since the start of the euro zone in 1999. The European Commission reported 12 May'10 that Estonia passes the tests to join. Standard & Poor raised Estonia's sovereign credit rating to A (from A1) on 10 Jun'10.

• Hungary's new government intends to cut taxes and stimulate the economy, but also to respect budget deficit target. The lack of clarity has unsettled financial markets and placed the government at odds with European Commission and IMF. Negotiations about a bailout package were suspended 17 Jul'10. Hungary's euro adoption appears further away than ever.

• Czech PM  Necas said (29 Jul'10) government won't commit to target date for euro adoption. Nor is entry into the Exchange Rate Mechanism ERM II being considered. Central bank Governor Singar said (22 Jun'10) that euro area has become less attractive. The independent monetary policy and currency allowed the country to better cope with the financial crisis. Target to be set once euro zone countries themselves meet the Maastricht criteria on budget deficits they demand from those wishing to join.

• Poland's central bank Deputy Governor said 7 May'10 that because of the Greek debt crisis Poland could not commit itself to a fixed date for adopting the euro. PM Tusk said 6 May euro adoption not priority. CBOS opinion poll conducted 18-19 Apr'10 showed for first time since 2007 more Poles opposed to adopting euro (49%) than in favour (41%). IMF said 10 May'10 Poland should not rush replacing zloty.

• Bulgaria's  plan to adopt euro in disarray when government revealed 8 Apr'10 off-budget spending by previous government. Intention  to join ERM II this year abandoned. European Commission is sending a mission to Bulgaria to investigate public sector finances.

• Romanian government stated (22 Mar'10) that Jan'15 remains its target date for adopting the euro. But European Commission critical of lack of reforms, high level corruption and organised crime (23 Mar'10).

• Fitch on 8 Mar'10 raised Lithuania's rating outlook to stable (from negative) on successful implementation of austerity. Moody's on 31 Mar'10 raised credit rating of Lithuania, Latvia and Estonia based on success achieved in surmounting recession and cutting wages to restore competitiveness.

      (more at members)

F O R E C A S T S

See below for Euroeconomics forecasts  of euro zone 1.  growth                           2.  inflation,
                                                                                              3. money market rates     4. Bund yields
                                                                                              5. stock market                 6. commodity price index
                                                                                              7. EUR/USD rate

Euroeconomics forecasts have been reviewed 3 Sep'10 in the light of the latest developments:

Fears of a slowdown in global growth, mainly fanned by poor US growth indicators, lessened in week 35 (which ended 3 Sep). 

In the euro zone the growth outlook shown by the latest surveys and indicators has been positive. Our GDP growth forecast for 2010 has been raised to 1.8% while the forecast for 2011 has been reduced to 2.5% (as the recovery is coming earlier).

Inflation indicators remain innocuous. The earlier uptrend in commodity prices and the oil price has partially stalled on global growth slowdown fears.

Though the ECB would like its monetary policies to be a little less accommodating and a little  more "normal", this may only be contemplated in Q1'11. In America the Fed may introduce additional stimulatory measures if the poor run of US growth indicators continues.

1. Growth:  how rapid a recovery?

Weak official forecasts

The currently available indicators leave little doubt that quite robust growth is underway in the euro zone. Official forecasts are still cautious even after a long series of upward revisions: euro zone GDP is seen to grow by 1.2% in 2010 (table below).

There are sound reasons for forecasting a difficult recovery. In the past recoveries have mostly been V shaped, but recoveries from recessions caused by banking crises have been more laboured. Any boost provided by restocking and fiscal support measures may be temporary. Moreover a sovereign debt crisis has erupted of unsuspected severity.
 

It is good to be cautious Having failed to forecast the 2008-09 recession forecasters are reluctant to be caught out again. It is more acceptable to underestimate growth than to overestimate it ("...we are pleased to say that growth is better than expected..." is a good deal more acceptable than "...we failed to see the recession dragging on..."). It is "good" to be cautious. This is particularly so in the current period of financial uncertainty when sight is lost of the fundamental forces driving economies. Forecasting is a subjective exercise, unduly influenced by the recent past. The consensus forecast for 2010 already had to be raised a number of times as the leading indicators strengthened in the summer of 2009. For instance in May'09 the European Commission expected euro zone GDP to decline by 0.1% in 2010. By May'10 it was revised to +1.0%. After the unexpectedly steep rise in Q2'10 GDP further upward revisions will have to be made.

Factors making for a weak recovery:

• over borrowed companies and households still need to de-leverage

• weak labour market inhibits consumer spending

• low capital utilisation inhibits fixed investment

• repair of the banking sector is seen to take time as more write-downs on loans and securities impair banks' ability to provide the economy with the finance considered necessary to support a sustained recovery

• the financial troubles of Greece and other deeply indebted euro zone countries have undermined confidence

• Greece, and to a lesser extent other  southern countries (Italy, Spain, Portugal), are introducing austerity measures

Pre-crisis growth (2003 to 2007) was supported by favourable financial conditions which proved unsustainable, restricting post-crisis growth. Growth beyond 2010 may be hampered by higher cost of capital due to higher risk premiums and lower leverage in private sector.

 

EURO AREA – GDP GROWTH  FORECASTS
Volume (in prices of 2000)	2008	2009	2010	2011	2009				2010
					Q1	Q2	Q3	Q4	Q1	Q2	Q3	Q4
	%  change  y/y				% change q/q, seasonally adjusted
Actual Official consensus forecast: (European Commission, OECD, ECB Staff, IMF)* Euroeconomics	0.6	-4.1	1.2  1.8	1.6 2.5	-2.5	-0.1	0.4	0.2	0.3	1.0	0.7	0.5
*for detail see growth variables

Factors making for a stronger recovery: pent up demand boosting domestic demand, weak EUR  boosting exports

In the autumn of 2008 the euro zone economy suffered a severe and unexpected shock. Suddenly money markets no longer functioned and bank loans became difficult or impossible to secure. The unavailability of finance and magnified uncertainty forced companies to slash inventories, investments and employment and hoard cash. Economic meltdown appeared to lie ahead.

By the spring of 2009 government fiscal policies and central bank monetary policies stabilised the economy, albeit at a low level. The world had not come to an end. The future looked less bleak. Financial markets began a sustained recovery.  The need for spending restraint eased.

• Spending decisions which were put off during the crisis are being revisited

• Replacement demand for machinery & equipment and durable consumer goods have built up and will increasingly be released

• The underlying forces which drive economies forward may have been blunted in the short term, but are progressively reasserting themselves. Technological progress is on-going spurring new investments and boosting productivity

• New households are being formed, spurring purchases of houses and household equipment, new consumer products and services are coming to market and attract spending

• Resources are released from shrinking sectors and are available for deployment in growing sectors

• The computer revolution has reached maturity and the work force is replenished by computer literates (taking the place of the computer illiterates moving into retirement), boosting productivity

• The steep decline in the EUR in H1'10 provides euro zone exporters with a powerful competitive advantage in selling to the newly industrialising countries, as well as to the developed countries

• J. M. Keynes's "animal spirits" (the "spontaneous urge to action rather than inaction") are particularly alive and well in the newly industrialising countries

• Growth in the global economy, spearheaded by the full blown boom in the newly industrialising countries, may again pick up momentum once the current soft spot in the US economy is overcome.

Euroeconomics forecast: greater emphasis put on the positive factors

Growth in the euro area is expected to be in the 2% to 3% region for the remainder of 2010 and for 2011. Though "optimistic" compared to the consensus forecast, this forecast still leaves by 2011 an output gap of  7%, representing the loss of output due to the financial crisis. (The output gap according to the consensus forecast amounts to 10%)
 

Comment on this forecast
 

2. Inflation:  to remain moderate

Low official inflation forecasts

The severity of the financial crisis has brought very low, even (briefly) negative, inflation rates. According to the official consensus forecast inflation will remain low: 1.3% is forecast for 2010 for the harmonised index of consumer prices (HICP). Even for 2011 the official consensus foresees inflation rising to only 1.5%, thus still clearly below the ECB's inflation target of "below but close to 2%."
 

EURO AREA – INFLATION  FORECASTS
%  change  y/y
Harmonised index of consumer prices	2008	2009	2010	2011	2009				2010
					Q1	Q2	Q3	Q4	Q1	Q2	Q3	Q4
Actual Official consensus forecast:  (OECD, ECB Staff, IMF, European Commission*) Euroeconomics	3.3	0.3	1.3  1.4	1.3 1.4	1.0	0.2	-0.4	0.4	1.1	1.5	1.6	1.6
*for detail see inflation variables

Factors making for moderate inflation: ample spare capacity, high unemployment, declining unit labour costs

Ample scare capacity is the major reason for expecting moderate inflation. As indicated above, GDP even in 2011 may still be some 7% below capacity limits.

Under pressure from still high unemployment, wage increases can be expected to be modest for a while yet. As output recovers unit labour costs decline. This allows companies to reap high profits even if prices charged remain stable.

Factors boosting inflation: vigorous commodity prices, weak EUR

Commodity prices in 2008, unsurprisingly, plunged from their pre-crisis peaks. Rather surprising was their steep recovery in 2009 and their continued, if at times more halting, rise in H1'10. Pre-crisis booming commodity prices reflected the global economic boom and, more particularly, the voracious demand for commodities from Asia's newly industrialising countries, China in the forefront.

The financial crisis has only briefly dented the expansion of these countries and probably accounts for much of the rapid recovery in commodity prices. Fears are that this relatively new and potent demand for natural resources, placed against inherently sluggish expansion in supply capacities, may lead to another commodities boom and eventually rekindle inflationary pressures in the developed world.

A relatively new element in the inflation outlook is the slide in the EUR to a value which, unless soon reversed, will have a moderate but perceptible impact on the euro zone inflation rate.

Taking these factors into account our own forecast for inflation are about in line with the consensus forecast.

 

 

Comment on this forecast
 

3. Money markets:  interest rates may return to normal in course of 2011

ECB to hike rates in 2011

Prospects of an export driven recovery in growth, coupled with subdued inflation, suggest that monetary policy may remain supportive in H2'10, then making way for gradual tightening.

The ECB, given its attachment to low inflation (see crusade against inflation), will wish to raise its main refinance rate from the current crisis level of 1% to a more "normal" 2% as soon as it considers that the recovery in growth has been secured. Supporting this move is the likelihood that inflation may move closer to the ECB's target rate of just below 2% now that the EUR has depreciated against the USD.

Our current forecast is for the ECB to maintain its main refinance rate at 1% in H2'10, then to raise it to 2% in the course of 2011. Money market rates which are currently sill below the main refinance rate may in the course of H2'10 continue to narrow the gap and converge on the main refinance rate in 2011.

Comment on this forecast
 

4. Government  bond  markets:  Bund yields to rise, eventually
 

After rebounding in H1'09 from their recession lows, 10-year Bund yields again declined in H2'09 on prospects that inflation would remain low for an extended period and hence monetary policy would remain accommodating for an extended period. Moreover the consensus view was that the recovery would be slow and fragile, further encouraging central bank docility.

In H1'10 the yield on Bunds declined further because of Greece's debt problems while the yield gap with US Treasuries for a while widened on strong US growth indicators. Towards mid-year the sovereign debt problem assumed major proportions bringing large safe haven flows into Bunds and US Treasuries. (see weekly chart).

Bund bulls say:

• Buyers of government paper are still bidding substantial amounts at auctions. Euro zone governments other than the most deeply indebted ones, have so far had no difficulty in selling the large quantities of securities required to cover their much enlarged budget deficits.

• The economic recovery may be slow and fragile, keeping the ECB from raising interest rates anytime soon.

• Generally, the ample liquidity made available to banks at exceptionally low interest rates allowed banks to borrow cheaply and invest the proceeds in higher yielding government bonds, boosting bank earnings and capital.

• Any problems afflicting the world economy or the euro zone economy in particular (such as the euro zone's sovereign debt crisis) may bring renewed safe haven flows into Bunds.

Bund bears say:

• The "safe haven flows" into Bunds on the sovereign debt crisis may reverse once the problem recedes.

• Budget deficits have exploded, requiring massive sales of government securities for years to come even as deficits are whittled down by restrictive fiscal measures.

• In the early months of 2010 Bund yields mostly fluctuated in the 3.1% to 3.4% range, then were dragged well below 3% as the Greek debt crisis spread and intensified. These rate are exceptionally low in a historical perspective. In 2009 inflation too was historically low. Thus real yields (nominal yields adjusted for inflation) were high. In H1'10 inflation has risen while Bund yields have declined, substantially compressing real yields.

• In longer term inflation may rise further and monetary policy may tighten, pushing bond yields sharply higher.

 

Our medium term outlook of accelerating growth with inflation creeping upwards and ECB policy normalising, implies that Bund yields will rise steeply. Public sector debt may have reached a peak but remains massive, requiring massive sales of government securities for years to come. Bund yields are expected to rise towards the 4.5% mark over our forecast horizon.

 

 

5. Stock  markets:  bright prospects

Stock markets made a steep recovery from the crisis low reached in Mar'09. During the following seven months to Oct'09 the recovery was almost as steep as the preceding slump. To a large extend this was because the initial fears of an economic collapse were not realised. As the government measures started to stabilise the situation stock markets recouped the losses resulting from those fears which proved overblown.

H1'10 brought setbacks as the Greek debt crisis intensified and broadened. Even the survival of Europe's monetary union was increasingly questioned. Fears of a global growth slowdown further undermined confidence around mid-year.
 

 

Favourable factors for the period ahead:

• exceptionally low money market interest rates
• recovery of growth boosting profits
• rapid deceleration in wage increases, coupled with rising output, to bring steeply declining unit labour costs

The early stages of an economic recovery are typically highly beneficial for corporate profits. Cost cutting during the recession, followed by rising sales during the recovery, make for a major boost to profits. Even moderate increases in GDP, i.e. moderate increases in corporate sales, generate disproportionately large gains in corporate earnings.

 

 

6. Commodity  markets:  strong demand, tight supply

 

Commodity producers (mostly located outside the euro zone) may be the major beneficiaries of the global economic recovery. Pre-crisis commodity prices soared as rapidly growing demand from the newly industrialising countries was amplified by speculative demand. The reversal of commodity prices during the crisis was brutal, but did not bring them back to their 2000-04 levels.

 

 

 

 

After being on a declining trend for the quarter of a century to 2000, real commodity prices have been lifted on to a rising trend thanks to the new demand from the newly industrialising countries. They still have a long way to go. Per capita consumption of commodities in developing countries is still only a fraction of the level in developed countries.

Supply for many commodities is slow to adapt to the increase of demand due to long lead times. The recession and the associated  difficulty of securing capital have brought further delays to capacity expanding projects.

7. EUR/USD exchange rate:  weak now, to strengthen later

After the EUR declined against the USD in H2'08 on safe haven flows into the American currency, 2009 brought a substantial recovery. Irregular early in the year, the EUR embarked on a sustained rise from April till early in December as the financial crisis faded and an economic recovery got underway. The USD lost its "safe haven" status.

The subsequent steep decline in H1'10 is due to Greece's excessive budget deficit and the difficulties it faces to finance it. This has unsettled markets, undermining the credit worthiness of other deeply indebted euro zone countries and even raising questions about the viability of the monetary union.

The outlook is now for the EUR to remain around the lower levels reached in mid-year, then strengthening once the euro area has recovered its balance and the defects the USD labours under move back into the limelight.

Factors boosting USD currently:

• US has moved first out of recession and may be first to tighten monetary policy. Relatively high US interest rates then to attract more capital inflows. US Treasuries already yield more than German Bunds.

• Renewed flaring up of financial crisis or other mishap (e.g. geo-political, or directly undermining the euro zone such as the recent Greek financial crisis) may bring renewed safe haven flows into USD.

• Purchasing power calculations indicate that EUR (at USD1.27) may still be overvalued by some 10%.

• Lack of internal cohesion of euro block due to divergent competitiveness of its members undermines confidence in EUR. Also recent problems have shown euro zone decision making to be slow and indecisive while divisions within the block led to weak compromises.

• Reputation and inflation fighting qualities of ECB undermined by events surrounding sovereign debt crisis.

Factors which may undermine USD later:

• Once euro zone's debt problems are resolved safe haven flows into USD may be reversed.

• Ongoing diversification of international reserves away from USD and towards other currencies, among which the EUR figures largely, may resume.

• Possible loss of confidence in USD due to America's deep budget and current account deficits, and fear of resurgent inflation.

• Though less substantial than earlier, US current account remains in substantial deficit (around USD500bn in 2010). May deepen again once consumer spending accelerates and/or oil and other commodity prices strengthen again. US current account deficit in 2010 is expected to amount to 3.7% of GDP, euro zone's to 0.3% (European Commission May'10 forecast).

• US budget deficit expected to amount to 10% of GDP in 2010, the euro zone's to 6.6% (European Commission May'10 forecast)

• US indebtedness to the rest of the world continues to increase from an already startlingly elevated level. At some unknown point the US may stop being credit worthy.

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