Why is the euro area slowing? My Weekly column

This post is available in pdf format My weekly column – January 15th

The euro area economy is slowing and could even see a contraction around the end of 2018 due to recessions in Germany and Italy, along with very weak momentum in France. The trend has changed at a faster pace than had been expected at the start of 2018, when the consensus was for similar trends to the very robust growth in 2017 i.e. no acceleration but continued swift economic growth. This pointed to expectations of more self-sustaining growth via jobs, income and investment, thereby driving a more independent trend that could safeguard some of the euro area’s economy against potential external shocks.
This quickening decline is worrying as the situation in a number of countries has gone from solid to shaky, for example Germany, where external trade is now hampering growth, along with Italy and France where domestic demand is no longer on the desired trend.
This quickening decline is worrying as the situation in a number of countries has gone from solid to shaky, for example Germany, where external trade is now hampering growth, along with Italy and France where domestic demand is no longer on the desired trend.

Why this perception of a swift deterioration in the euro area economy?
The first harbinger that all economic observers picked up on is the very swift deterioration in economic indices as measured by business leaders surveys. From a peak in the last quarter of 2017, the composite index slid swiftly and steadily right throughout 2018, failing to display a recovery. This trend is revealed in the euro area Markit manufacturing sector index, which slowed severely and sustainably in sync with world trade, with an accompanying drop in domestic and external orders.

Eurozone recession?

The horizon darkens faster than expected in the Euro zone.
The German figures published this morning (January 8) suggest that the economy is heading towards recession (its GDP had already fallen in Q3). Italy, also with declining GDP in Q3, has negative signals via business surveys. It is also probably in a recession. The French economy lacks vigor, social unrest weighs heavily on the macro dynamics.

In other words, 65% of the Euro zone is probably in decline in the last quarter of 2018 (German and Italian declines do not make up for France’s slight rise). This creates a mediocre momentum and a real concern for the pace of growth of the area for the coming months.
In a context where inflation will be reduced, this will result in poor nominal growth that will not have the ability to create and distribute income. Better coordination of economic policy is a necessary condition (but probably not sufficient) to find a satisfactory trajectory.
Alas, we do not take that path. The two Italian deputy prime ministers blow on the French embers and do not encourage to imagine a serene future.

Germany in recession ?

Recent data on the German industrial production show a rapid drop in the economic activity. The quarterly change was already at -5.5% in the third quarter (annual rate). At the end of November, the carryover for the last quarter of 2018 is at -7.8%.
There is a strong consistency between the quarterly change in the industrial production index and the GDP as it is shown on the graph.
During the third quarter of 2018 the GDP was down -0.8% and related to the strong decrease in the German production this winter, the GDP may again shift downward in the last quarter. Germany would then be in recession.
The impact could be strong on the Euro Area’s momentum and leading to a downward revision of the EA growth forecast (the starting point for 2019 would be lower). The convergence to potential growth (1.6%) would then be quicker than expected.
The ECB will not change its monetary policy before long.

ISM index dropped: a healthy adjustment.

ISM index dropped: a healthy adjustment.
In the USA, the fall of the ISM may reflect a return to a more normal situation? For many months, this indicator for the manufacturing sector was well above the CFNAI index which is a measure of 85 indicators of the economic activity (prepared by the Chicago Fed).
This situation, which has been a regular occurrence since 2004, always ends with a sharp and brutal adjustment of the ISM to the CFNAI. The adjustment always takes place in this direction. Finally, the overly optimistic expectations contained in the ISM index adjust to the “real economy” which does not present excessive optimism. This adjustment is rather healthy. 

INSEE expects a moderate recovery in activity in 2019

The latest outlook note from French national statistics body INSEE (full-length version in French, English summary available here) suggests that the French economy will not be affected on a sustainable basis by the recent wave of social unrest in the fourth quarter of the year. The pace of growth over the first half of 2019 fits with the trend witnessed since 2013, apart from 2017, which was an exceptional year.We can see this return to normal on the chart below, showing the half-on-half change in economic activity as reflected by GDP. The pace has returned close to pre-2017 stats and growth is near its potential rate. In these figures, average growth is set to come to 1.5% in 2018 and carry-over at the end of 1H 2019 at 1%.

We can see this return to normal on the chart below, showing the half-on-half change in economic activity as reflected by GDP. The pace has returned close to pre-2017 stats and growth is near its potential rate. In these figures, average growth is set to come to 1.5% in 2018 and carry-over at the end of 1H 2019 at 1%.

France: the growth momentum is lower than expected

The French government is still expecting a robust recovery for the last three months of 2018 and for 2019. Companies’ surveys for October do not allow such optimism. 
The main point is the rapid slowdown in the manufacturing sector. It was the leading sector in 2017 and its dynamics was an important contributor to the strong expansion seen this year. It was a source of impetus for the rest of the economy. 
Its current lower momentum is a source of concern. The retail sales sector is weak reflecting question on purchasing power for every French consumer.
My expectations is that the French economy is back to the trend seen before 2017. It means that the forecast for GDP growth is close to 1.4%. This is consistent with what these surveys say. No strong recovery is expected and the French economy will converge to its potential growth which is lower than 1.5%.
The following graph shows the transitory recovery of 2017.france-semester growth.png 

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Is the ISM index a bubble?

The ISM index for the manufacturing sector is, in August, at its highest since May 2004. It was then at 61.3 versus 61.4 in May 2004.
The reading of this index is puzzling for different reasons
1 – Since 2011, the average growth in the US is 2.2% but the trend was 2.7% between 2000 and 2007. But the ISM index was, on average, higher since 2011 than before the crisis. Its average was 54.1 from January 2011 to August 2018 but only 52.1 from January 2000 to December 2007. A higher ISM index doesn’t not reflect a stronger growth momentum. We can see that also when looking at the manufacturing production index. On the same periods, the annual growth rate was 1.8% from 2000 to 2007 but 1.15% from 2011 to July 2018.
In other words, the index is higher than in the past while growth is lower. 
2 – There is a robust index calculated by the Federal Reserve of Chicago. The CFNAI (Chicago Fed National Activity Index) is the synthesis of 85 indicators (industrial production, employment, personal income,….). It’s reading is easy with an average at zero and a standard deviation of one.
The CFNAI is an accurate measure of the business cycle based on observed variables. Usually the two profiles are consistent as the graph shows.
Recent data show a persistent divergence between the two. The CFNAI is close to 0 while the ISM is at a high historical level. It is probably too high giving a wrong signal of the US growth strength.ismcfnai-summer2018.png