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.

The flattening of the yield curve and the possibility of a recession in the US.

First step the 5yr-2yr spread is now null before being negative with the Fed tightening. Then the 10yr-2yr will flatten before being negative for the same reason. This has always been a signal of recession. This time is not different and 2020 can be anticipated for it.
The two curves have the same pattern even if levels are different. They provide the same message for 2020.

The flattening of the US yield curve is a source of concern – This time is not different

Jerome Powell said that the yield curve flattening was not a source of concern and that it wasn’t showing a risk of recession as the economy is following a strong trajectory.

This point of view can be challenged for at least two reasons

1 – A negative yield curve (10 year rate below 2 year rate on government bonds) has always been a signal of recession with a lead of 18 to 24 months. The following graph is clear. Each negative yield curve is followed by a recession with a lag. The current spread is lower than 30 basis points, almost one increase of the fed funds rate.

We expect this yield curve profile for the end of this year due to the tighter monetary policy and therefore we have a strong probability of recession for 2020.

2 – The yield curve flattening reflects higher short term rates and no strong expectations on the long duration side showing that investors do not forecast a bright and strong future.

The tighter monetary policy means that the funding of the economy will be constrained for consumers and companies. We’ve seen recently that companies’ debt (as % of GDP) is at a record high and that consumer credit is still increasing rapidly. The impact of higher short term rates will be negative for both of them.

On the real estate market, around 50% of the financing is coming from brokers whose funding is linked to short term rates. For them too the situation will dramatically changed.

Moreover, an expected tighter monetary policy has provoked higher mortgage rates which will be damaging for households as real wages are no longer creeping up.

The argument saying that “this time is different” must be related to the discussion Reinhardt et Rogoff had in their famous book “This time is different”. Investors always think that the situation, at the moment they live it, is different from what was observed in the past with same type of signal. Reinhardt and Rogoff just say that it is not different on financial markets. An unbalanced situation must be adjusted. Current sources of “this time is different” argument are based on the neutral and non observable long term rate and also on the Fed’s balance sheet operations that have an impact on long bonds through the Fed’s reinvestment of their portfolio proceeds

In other words, the impact of higher short term rates will be negative on the US private sector and could be the source of the expected lower momentum on the economic activity. It it just the impact of a tighter monetary policy as we’ve always seen it in the past. This time is not different.

A discussion of Jay Powell’s speech at the congress can be read in the following FT article