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Will the Economic Expansion in the Eurozone Last?

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Will the Economic Expansion in the Eurozone Last?

We have seen a lot of events unfold in the European Union (EU) over the past year: including the British referendum seeking an exit from the European Union (Brexit) and a populist anti-EU sentiment seemingly gaining steam across the region. This led to higher volatility in equity markets and created dark clouds over Europe’s economic recovery. However, recent elections in the Netherlands and France saw a resurgence of the pro-EU side. This gives the EU, and perhaps the European Central Bank, some space to allow for a cyclical recovery to take hold. In addition, we believe it also allows the bloc to take a more united stance as the Brexit negotiations get underway.

In this paper, we examine improving aggregate economic conditions in the Eurozone (countries that use the euro currency). We discuss whether this recovery can be sustained and potential risks that can get in the way.  We  start by looking at the resurgence in manufacturing within the bloc, followed by the pop in European inflation, since it is a good gauge of where the recovery stands today, not to mention an important signpost for monetary policy going forward.

Manufacturing boom

The greatest optimism for Europe’s recovery comes when looking at manufacturing data. Manufacturing PMI, which measures the overall sentiment of the manufacturing sector, has also improved significantly over the past year. A PMI level below 50 implies sector contraction, while a PMI level above 50 implies sector expansion. PMI levels were only slightly higher than 50 for the early part of 2016. However, as Exhibit 2 illustrates, the index has raced upwards since September 2016, and currently sits at 56.7 (as of April 2017), indicating that Eurozone manufacturing is expanding at its fastest pace in six years.

The positive manufacturing data is also underpinned by the fact that surging exports have led Europe’s trade surplus with the rest of the world in March to its widest since 1999 (when the euro was launched). Exhibit 2 shows the recovery in exports, with external trading partners as well as within the bloc. March trade figures indicated that external exports grew at its fastest annualized pace since May 2015. At the same time, internal exports were growing at their fastest pace since September 2011. Since members of the bloc mostly trade with each other, the fact that internal exports are rising rapidly points to higher demand within the union, which is a significant positive signal for the recovery.

For example, in the Netherlands, nearly 30 percent of total imports come from fellow Eurozone members like Germany, Belgium, and France. Dutch exports to those same countries amass over 41
percent (21 percent to Germany, 14 percent to Belgium, and 6.2 percent to France). Therefore, rising domestic demand within the bloc would result in higher manufacturing demand and exports.

Inflation pops

Unlike the United States, the Eurozone (European countries that use the euro currency) has been plagued with negative and zero percent inflation rates over the past several years. In fact, Eurozone inflation had remained below the 1 percent level since September 2013. It finally broke that barrier in December 2016, when inflation rose to 1.4 percent.

Headline inflation started to spike in November 2016, coinciding with the election of Donald Trump as President of the United States and the potential for significant reflation amid fiscal expansion in the U.S. However, as Exhibit 3 illustrates, headline inflation was already on its way up since May 2016, mostly due to energy prices rebounding.

That rising energy prices were a major factor behind climbing inflation numbers is supported by the fact that headline inflation rose with energy prices, and has eased more recently as energy prices leveled out. Headline inflation fell from 2 percent in February to 1.5 percent in March, before rebounding to 1.9 percent in April, coinciding with a similar movement in energy prices. Interestingly, core inflation, which strips out volatile food and energy prices, fell in March before jumping to 1.2 percent in April, the highest inflation rate since June 2013. This is primarily due to price distortions from the Easter holiday, as the holiday occurred in March last year and April this year.

Diverging fortunes

The upbeat economic data, especially solid manufacturing and export numbers, is yet to show up in overall GDP growth. While real GDP growth hit 1.80 percent in the fourth quarter of 2016, it eased to a 1.70 percent annualized rate in the first quarter of 2017, continuing the trend of sub-2 percent growth rates since 2015. Aggregate economic data can mask the fact that the individual countries within the bloc are seeing vastly different growth prospects. Focusing on the overall forest can hide the fact that some of the trees within face deep structural issues.

The Netherlands and Spain saw their economies expand at an annualized pace of more than 3 percent in the first quarter, while Europe’s economic powerhouse, Germany, saw fairly robust growth of 1.7 percent. At the same time, France and Italy saw heir economy expanding at a less than ideal pace of 0.8 percent in the first quarter.

Understanding the divergence between various countries that make up the union gives us a better idea as to what areas are buttressing Europe’s apparent recovery, and which areas continue to struggle.

Germany, Netherlands and Spain shine

Given the positive manufacturing data, it is no surprise that the two countries most reliant on manufacturing and exports, Germany and Netherlands, continue to see robust growth, brushing off economic and political risks that have been plaguing other parts of Europe. Manufacturing PMIs in the two countries are amongst the highest in the bloc, coming in near the 58 level in April. Both countries also saw exports hitting all-time record highs in March 2017. Exports from Germany rose at 10.8 percent year-on-year in March, while Dutch exports surged 16.6 percent in the same month.

One indicator that provides the best overall snapshot of the German economy is the Ifo Business Climate Index. The index is a broad but early economic indicator that is published monthly. It primarily measures the sentiment among business managers and computes an index ranging from -100 (all respondents are pessimistic) to 100 (all respondents are optimistic). The index is an early indicator of economic growth, as shown in Exhibit 4.

Business owners have clearly been growing more optimistic as 2017 began. The index has risen steadily since late December, with April’s rating coming in at 112.9, the highest rating since July 2011. This portends well for Germany’s economy crossing above the 2 percent growth rate mark in 2017.

The other country that has recently seen an economic upswing is Spain, which belies that notion that Europe’s south is uniformly struggling. Unlike Germany and the Netherlands, the real driver of economic growth in Spain is consumer spending. Spaniards are clearly more confident now, with consumer confidence numbers hitting their highest value since December 2015. Increased confidence is leading them to open up their purse strings, with consumer spending powering the economy to a 3 percent annualized growth rate in the first quarter of 2017. Retail sales, which declined in January and February, bounced back in March. A key factor behind the Spanish economy firing as fast as it has, on the back of consumer spending, has been a rapidly improving labor market. The unemployment rate, which was above 25 percent less than three years ago, has fallen to 18.75 percent (as of Q1 2017). Youth unemployment, which was higher than 55 percent in 2013, came in at 40.5 percent in March. These numbers are still high, but the fact that they are falling quickly is an encouraging sign.

One note of caution with respect to Spain is its higher inflation rate. Headline inflation climbed as high as 3 percent in early 2017. At the same time. core inflation , which omits more volatile food and energy prices, remains subdued, close to the 1 percent level. Nevertheless, higher food and energy spending would raise the cost of living and limit disposable income for Spanish households. Headline inflation fell to 2.6 percent in April, which is an encouraging sign and if it continues, bodes well for the Spanish consumer.

France and Italy lag

Labor markets in France and Italy continue to frustrate, with the unemployment rate stuck above the 10 percent level and showing no sign of falling. Wages have also been growing at less than 0.5% annually, putting downward pressure on household spending and consumption.

At the same time, French and Italian manufacturing has continued to expand, with manufacturing PMIs of 55.1 and 56.2, respectively – the highest levels in more than five years. Nevertheless, a buoyant manufacturing sector is insufficient to overcome structural issues, especially in the labor market.

A new, committed ruling government in France could provide for some much needed reforms to help boost the struggling labor market. Most notably, dealing with large unemployment benefits and burdensome taxes and regulations. The risk is the newly elected French President, Emmanuel Macron, fails to get a parliamentary majority that can enact his agenda.

Likewise, Italian leaders have prioritized labor market reforms, especially lowering the cost of labor and addressing high unemployment among women and young adults. The government also seems at a loss with respect to resolving Italy’s troubled financial sector – an issue we will delve into in a later section.

Central bank support continues, for now

With inflation making a comeback, the sentiment within the European Central Bank (ECB) is clearly improving and there is renewed optimism that monetary policy is working. The central bank appears to see less of a need to take further stimulative action. In fact, the opposite appears to be happening. Their asset purchase program is slated to continue into the latter half of 2017, though the level of purchases was reduced from €80 billion to €60 billion in April. Interest rates are also expected to remain unchanged, with the ECB signaling that they will be patient and watch whether economic growth is sustained.

At the same time, German and Dutch officials are exerting more and more pressure on ECB officials to begin the tightening process sooner rather than later. ECB President, Mario Draghi, was recently subjected to an extensive grilling on their stimulus measures by members of the Dutch parliament – the members ended the session with a gift of a tulip for Mr. Draghi, to remind him of the country’s famous Tulip Mania asset price bubble in the mid-17th century.

The ECB hiked rates in 2011, when clearly rate hikes were not warranted, and was too slow in providing monetary policy support between 2012 and 2015 (when it finally began asset purchases) – mostly due to policy hawks in Northern Europe. It remains to be seen whether the ECB can withstand pressure to prematurely tighten policy this time around, and whether central bankers can commit to letting inflation remain at their target, or even overshoot it for a small period of time.

Any tightening by the ECB is likely to lift bond yields, especially in countries like Italy, who can ill-afford to see such a rise. This is perhaps one of the biggest tail risks facing Europe.

Risks for the bloc

Italian financial stress and ECB policy tightening

The potential tapering of the ECB’s quantitative easing program, and tightening of interest rate policy, poses a huge problem for Italy, and thereby Europe. Italy’s bad debt problem is perhaps Europe’s weakest link, and it continues to confound potential solutions. Last year, all eyes were on Italy’s crumbling financial sector, with fear that 360 billion euros worth of sour loans would crash the Italian economy and spread across Europe to countries that have exposure to Italian financial sector debt – most notably France, Germany, and Spain. As the central government in Italy moved to provide liquidity to several banks, the country had to maneuver around an EU rule that prohibits governments from bailing out its banks before bondholders and stakeholders take a percentage of the liabilities. In late December 2016, the government approved 20 billion euros of funds to be injected into a variety of Italian financial institutions to keep them afloat. However, this may not be enough.

Italian banks have been unable to securitize NPLs and the loan problem seemingly refuses to improve, in sharp contrast to the situation in countries like Spain and Ireland. The overall stock of bad loans for fifteen Italian banks fell in 2016 for the first time in eight years, but the proportion of the worst class of bad loans, those with insolvent borrowers, rose slightly.

There are 24 Italian banks with a Texas Ratio (TR) of over 200 percent. The Texas Ratio takes a bank’s total non-performing loans and assets and divides this figure by the firm’s tangible book value in addition to its reserves. The higher the ratio, the more trouble the bank is in. Many banks with high TRs are small financial institutions, which is worrisome but may not pose a systemic risk to the country, by themselves.

However, as Exhibit 5 shows, there are some large banks that in fact do pose a systemic threat to the country and parts of the region. Monte dei Pashci di Siena is one of the largest banks in Italy with 169 billion euros in assets. The bank has been bailed out multiple times before, but continues to be exposed to a significant number of non-performing loans, with a TR of 262.8 percent.

Monetary policy tightening will hit Italy hard, since it has become increasingly dependent on the external support. ECB QE has helped cover the reduction in Italian government bond exposure by international banks, especially German banks. However, as QE is wound down, demand for Italian debt will further reduce and yields will rise. The only market participants holding significant amounts of Italian debt will be already troubled Italian banks that can ill-afford to see rates rise on that debt, and the value of their collateral reduce.

With the financial sector in shambles, and no real plan on the Italian or European side to resolve it, we could be witnessing a slow-but-steadily moving banking crisis that could once again threaten the European project, let alone its nascent recovery. In a recent address to financial markets, Giuseppe Vegas, the chairman of CONSOB (Italy’s stock market regulator), perfectly captured Europe’s quandary:

“The management of the crisis may require lightening interventions incompatible with the decision-making mechanisms in Frankfurt”.

An eventual bailout by the ECB is not entirely out of the question, like the Greek bailout in years’ past (and continuing to this day). However, that requires votes by ECB member countries, which would be extremely difficult. An Italian bank bailout is likely to be accompanied by onerous terms that Italy may find politically difficult to stomach. Unlike Greece though, Italy is a significantly larger member of the Union and we could see a high stakes game of chicken being played out, with the future of Europe at stake.

Greece continues to struggle with heavy debt load

Even though Greece is no longer one of the most discussed issues facing the EU, there are still real concerns about the country’s debt. An IMF report that circulated in January stated that Greece’s debt load would reach 170 percent of GDP by 2020 and grow to 275 percent by 2060. Greece, which has been receiving financial bailouts from various institutions since May 2010, is now on their third financial assistance program as of January 2017. In exchange for loans, Greece had to agree to 140 legislative actions and reforms, ranging from healthcare changes to providing additional powers to independent government agencies.

As the country moves forward with deep and punishing structural reforms, the government is pressuring the EU and the IMF to agree on a debt relief package. While both parties have conceded that Greek reforms are sufficient for release of new bailout funds, the IMF does not want to join in the new round of financing without Europe giving Greece debt relief.

The obvious obstacle here are the Germans, who are wary of providing debt relief, especially prior to elections in September. They also fear that providing debt relief to the Greeks will leave the lenders with less leverage over the Greek government, giving the Greeks an opportunity to pull back on promised reforms. At the same time, the IMF maintains that Greece cannot grow as much as Europe expects, let alone sustain large primary budget surpluses for a long time (projected to hit 3.5% of GDP by 2019). However, Berlin wants Greece to maintain these surpluses for an extended period, thereby reducing the need for debt relief.

Absent another round of financing by the third quarter of 2017, Greece risks default and Europe will once again face turmoil over Greece’s debt situation, not to mention renewed speculation of “Grexit”. At this point, the IMF appears willing to simply accept a commitment by Europe to offer Greece debt relief “if necessary”, as opposed to a detailed schedule. It remains to be seen whether Germany will be open to even this option, which would mitigate any crisis in the short-term but simply kicks the can down the road.

Brexit

One historically iconic moment that continues to develop is the United Kingdom’s exit from the European Union (termed Brexit). After 44 years as a member of the European Union, Prime Minister Theresa May invoked Article 50 of the Lisbon Treaty on March 25th, which officially signaled the beginning of the divorce process between Britain and the EU. To keep momentum and prevent the opposition party from slowing the negotiations down, Prime Minister May announced a surprise election in June to, hopefully, increase majority control in Parliament. If her party does not do well, that would undoubtedly raise uncertainty in Britain and (possibly) the EU markets. Currently, however, Prime Minister May’s Conservative Party holds a 22-point lead in the most recent poll.

As the UK government continues to formulate a negotiation strategy, European Union officials have indicated that negotiations will be difficult, and perhaps not as simple as British officials currently hope. For example, the British were hoping to negotiate a trade deal with Europe in tandem with Brexit negotiations, but EU officials have made clear that this will not be the case. Talks for a potential trade deal (which will take years to negotiate in any case) can only occur after Britain has formally exited the union.

Exhibit 6 shows that the UK is a lot more dependent on trade with the EU, than the EU is with the UK, giving the bloc some leverage in trade negotiations. However, the fact that countries like Germany and Netherlands are focused on export-led growth, means they will have some incentive to continue maintaining smooth trading relations with the UK. The UK accounts for close to 8% of exports from Germany and 10% of exports from Netherlands.

The EU will also insist that Britain grant permanent residency for European Union citizens who move to the country before 2019 (the scheduled end-date of the negotiations) and plan to stay for five years. The EU will also be seeking monetary payment from the UK, as the British government committed to a seven-year EU budget plan in 2014. The Germans, who have been vocal in their demands for the UK to pay their fair share to leave, view Brexit as a moment to set an expensive precedent, so as to prevent others from seeking a way out of the bloc.

In addition to the possible trade implications, capital movement may also cause problems if not addressed during the negotiations. London has a leading role as the financial hub of Europe, but that could be threatened. After Prime Minister May triggered Article 50, financial institutions have been doing their homework, and have begun actively shopping potential relocation sites for their European operations. J.P. Morgan and Citigroup are among just a few institutions that are actively exploring relocation from London, and others, too, are exploring key cities in Germany, France, the Netherlands, and Belgium. Although it is uncertain whether many of these companies will ultimately choose to relocate (and relocate to the same city), some Eurozone countries may see economic benefits.

Is this time different for Europe’s recovery?

Over the past decade, we have seen green shoots of recovery repeatedly emerge in Europe, before a crisis halted further progress. Economic recovery after the 2008-2009 recession lasted only briefly, before the debt crisis engulfed southern Europe between 2011 and 2012. Economic growth peaked in the third quarter of 2011 and hit a low point by the first quarter of 2013. The subsequent recovery then stalled as austerity measures in debt-ridden European nations like Spain and Greece resulted in political blowback, ultimately culminating in the Greek debt crisis of 2015. A temporary resolution to the crisis, combined with the ECB resorting to extreme stimulative measures that included asset purchases and negative interest rates, put Europe back on a path of economic growth. However, the Brexit referendum created renewed upheaval in Europe, along with rising anti-EU sentiment across the region.

Convex’s proprietary leading economic index (CPLEI), which rates the economic environment of thirty countries across the globe monthly, indicates that Europe is once again perched on the road to recovery. CPLEI for the Eurozone, shown in Exhibit 7, captures the story of several leading economic indicators for the region and tells us that the bloc may be poised to enter a period of expansion. The Eurozone is currently rated as Hold-Buy. We do stress that the CPLEI is a nowcasting mechanism, as opposed to a forecasting tool, thus giving us a snapshot of the economy as it stands today.

The EU will also insist that Britain grant permanent residency for European Union citizens who move to the country before 2019 (the scheduled end-date of the negotiations) and plan to stay for five years. The EU will also be seeking monetary payment from the UK, as the British government committed to a seven-year EU budget plan in 2014. The Germans, who have been vocal in their demands for the UK to pay their fair share to leave, view Brexit as a moment to set an expensive precedent, so as to prevent others from seeking a way out of the bloc.

In addition to the possible trade implications, capital movement may also cause problems if not addressed during the negotiations. London has a leading role as the financial hub of Europe, but that could be threatened. After Prime Minister May triggered Article 50, financial institutions have been doing their homework, and have begun actively shopping potential relocation sites for their European operations. J.P. Morgan and Citigroup are among just a few institutions that are actively exploring relocation from London, and others, too, are exploring key cities in Germany, France, the Netherlands, and Belgium. Although it is uncertain whether many of these companies will ultimately choose to relocate (and relocate to the same city), some Eurozone countries may see economic benefits.

Is this time different for Europe’s recovery?

Over the past decade, we have seen green shoots of recovery repeatedly emerge in Europe, before a crisis halted further progress. Economic recovery after the 2008-2009 recession lasted only briefly, before the debt crisis engulfed southern Europe between 2011 and 2012. Economic growth peaked in the third quarter of 2011 and hit a low point by the first quarter of 2013. The subsequent recovery then stalled as austerity measures in debt-ridden European nations like Spain and Greece resulted in political blowback, ultimately culminating in the Greek debt crisis of 2015. A temporary resolution to the crisis, combined with the ECB resorting to extreme stimulative measures that included asset purchases and negative interest rates, put Europe back on a path of economic growth. However, the Brexit referendum created renewed upheaval in Europe, along with rising anti-EU sentiment across the region.

Convex’s proprietary leading economic index (CPLEI), which rates the economic environment of thirty countries across the globe monthly, indicates that Europe is once again perched on the road to recovery. CPLEI for the Eurozone, shown in Exhibit 7, captures the story of several leading economic indicators for the region and tells us that the bloc may be poised to enter a period of expansion. The Eurozone is currently rated as Hold-Buy. We do stress that the CPLEI is a nowcasting mechanism, as opposed to a forecasting tool, thus giving us a snapshot of the economy as it stands today.

The hard, and soft economic data, especially manufacturing and trade numbers, give us reason to be optimistic about Europe’s recovery. However, as we discussed earlier, the positive aggregate data can mask the fact that there are big differences between the individual members of the bloc.

Countries like Germany and Netherlands, which are dependent on manufacturing and exports, are witnessing robust growth, as is Spain, where consumer spending is driving economic expansion. Absent any external headwinds, or renewed crisis, these countries appear poised to continue along their recent trajectory. At the same time, countries France and Italy face structural problems, especially in their labor markets.

Central bank support has also provided a boost, though policies that implicitly lower the value of the currency disproportionately help countries that rely on export-led growth. It remains to be seen whether the ECB will succumb to pressure and tighten policy prematurely, risking economic recovery, let alone the prospect of another debt-crisis.

Europe has several issues to resolve, most immediately Italian banks and Greece’s debt. On the face of it, these seem to have rational solutions that can lead to ultimate resolution. However, the problems appear to be as intractable as ever thanks to the political realities that exist within the bloc, perhaps highlighting the structural flaws of the European project.

In the short-term, Europe always seems to find a temporary solution to an emerging crisis, causing short-term bouts of optimism. However, these solutions are not lasting and the problem continues to simmer along, eventually resulting a renewed crisis.

Over the long-term, countries like Italy and Greece will continue to face the constraints of holding onto a common currency, without the advantage of being part of a common fiscal or banking union. The inability of the Eurozone to move toward joint debt issuance, and reluctance to greenlight fiscal stimulus across the region, will hamper efforts to fight future recessions, let alone a major financial crisis. The disparity between economic fortunes of individual members of the bloc, and lack of political will to find solutions that work for everyone, means that the ties binding Europe remain strained.

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