25 November 2018

The European economy surged between mid-2016 and the end of last year — expanding at an impressive 3% annual clip during this interval. This year has been quite a different story, as growth has consistently disappointed: indeed, GDP advanced a meagre 0.8% (annual rate) during the third quarter of 2018. There are no shortage of possible causes: Brexit, Italian fiscal woes, transatlantic trade tensions, adverse French reaction to President Macron’s reforms, and Chancellor Merkel’s political travails. Are the dark clouds of recession gathering even before the ECB begins to normalise monetary policy? Alternatively, if these political risks fade (a very big IF), will Europe bounce back, or is this tepid pace of economic growth reflective of what to expect in the wake of the Global Financial Crisis?

2018: Disappointment and Divergence………

The Chart illustrates the persistent deceleration in 2018 economic activity. Moreover, recent PMI surveys (November’s was released last Friday) suggest that the weakness continued into the fourth quarter. Indeed, Q4 GDP may well have stagnated — bringing the YOY result to only 1.1% compared to 2.7% in Q4 2017.

The slowdown has been most evident in the industrial sector. To be sure, the slump in the automotive area has been pronounced, as the industry responds to altered emissions standards. While the impact may not be over just yet, this will be a temporary hit to Europe’s factory sector. Nevertheless, the following Chart highlights that industrial activity outside the auto sector has decelerated this year also.

The breakdown of growth by country is also revealing. Germany’s slump has led the way: GDP actually contracted (0.8% at an annual rate) in Q3, reflecting the auto sector’s adjustment.  Output in Italy, meanwhile, stagnated during the interval following financial market volatility. And, Brexit continues to take its toll on UK activity (although on a quarterly basis the UK’s 0.6% gain was an unexpected improvement). Spain has been outperforming. And, Emerging Europe (an outsourcing location for German car manufacturers) has managed to shrug off the problems in Germany.

Moreover, Europe’s economic performance stands in stark contrast to the USA’s — where tax cuts have fueled a 4% surge in GDP during the past six months. This divergent economic pattern has been reflected in a similar divergence in ECB and US Federal Reserve monetary policies. This gap has paved the way for the US dollar’s appreciation — a pattern which should continue in coming months.

……..But, Traditional Signs of Recession Still Not Evident

Despite recent disappointing trends, the traditional harbingers of recession are not yet evident.  In particular, downturns usually result from excessive monetary tightening in reaction to mounting wage and price inflation.  The following Chart illustrates neither exist.  Core inflation remains steady near 1% (left scale). Labour  costs have risen only 1.8% in 2018 so far, the same pace as last year (right scale).  While headline inflation at 2.2% is above target, the recent collapse in energy prices will bring CPI back below 2% next year. Thus, I expect core inflation to remain below both the ECB’s forecast and its 2% target through the end of 2020.

Prior to downturns, additionally, rising wages traditionally erode corporate profitability, choking off pre-recession capital spending booms. None of these ingredients are now evident. The Chart illustrates that profit margins are rising, but remain below peak levels. I expect European EPS to grow 9% (a far cry from the S&P500’s 25% gain) this year and another 5% in 2019. Likewise, business investment is not booming, but rather has advanced at a healthy 3.3% YOY pace this year (actually rising 6% at an annual rate during H1 2018).  Capex should post similar modest gains again next year.

Likewise, after years of budget cuts, European fiscal policy should provide a boost to 2019 GDP growth. Indeed, UK Prime Minister has announced recently “the age of austerity is over”! Italy’s budgetary stance also has famously turned stimulative, although the rise in bond yields may negate the impact. Germany is easing the reins, but could/should do more.

European consumer spending should remain steady, if unspectacular.  As mentioned earlier, modest pay gains will limit income growth (although lower energy prices will provide a boost). The next Charts reveal that following the surge in hiring in 2016/17, employment growth has again cooled recently towards its longer term trend pace. Consumer confidence this year has remained more elevated than actual spending, but sentiment appears to have tailed off lately as the economy has slowed.

What has been the impact of the Trump Administration’s aggressive warnings about a trans-atlantic trade war? To be sure, European export volumes have slowed this year: advancing 3.5% compared to 5.6% in 2017. However, the USA is not the problem, as sales have surged. Problems in Turkey, Russia, and OPEC (perhaps reflecting lower oil prices) have been the main culprits. Sales to China are considerably slower, but still healthy.

I expect that after some huffing and puffing, a US-EU trade conflict will be averted (as has been the case with Korea, Canada, and Mexico). However, the benefit of surging sales to the USA will decline as impact of US tax cuts fades next year. As the global expansion slows in 2019, therefore, external demand can not be relied upon to propel  European growth.

Intra-European trade has also slowed. Brexit appears to be having an adverse impact. EU-27 (ex UK) sales to Great Britain have declined 1% this year (compared to only a modest 2% gain in 2017). The impact of Italy’s volatility is not evident yet: EU sales to Italy are up nearly 4% (value terms) this year, although Italian imports from the EU did slump 3.4% in September.

Returning to Normal: Limited Reform = Limited Growth

In fact, the 2016/17 economic surge is likely to prove to be the exception to the rule. The following Chart illustrates the slowdown in Europe’s productivity pattern. Indeed, this a world-wide phenomenon, but Europe has underperformed the USA for decades. And, efficiency does not appear to have improved sustainably lately. Along with weak demographics – – slow-growing population and labour force — Europe’s long-term GDP growth potential is ony about 1.3%.

Without meaningful reforms aimed at boosting investment and productivity and establishing an immigration policy supportive of economic activity, the current slowdown simply reflects a return to the region’s tepid long-term growth trajectory. Unfortunately, the impetus for EU-wide reform, so evident following President Macron’s election, appears to have faded.  Weak productivity will continue to  limit the improvement in living standards sought by  Europe’s electorate; thereby, sustaining the appeal of populist, nationalist political movements.  Likewise, sluggish trend GDP growth increases the risk that the region could be tipped into recession by political, economic shocks or policy mistakes.

Political Risks: Not Likely to Fade Soon

Europe’s outlook remains besieged by political risks, which sadly will not quickly fade. I have dealt with most of them in earlier blogs, so I will make just a few quick observations:

• Brexit:  Whenever Remainers make the obvious point that Brexit will damage the UK’s economy, Leavers dismiss such projections as “Project Fear”, and remind us that negative pre-referendum gloom turned out to be inaccurate. Two years on, we do need to rely on forecasts. The following chart highlights the underperformance of the UK economy (beating only Italy). Brexit is already adversely impacting trade with the EU-27, and will remain a headwind for European growth for years to come.

I expect Prime Minister May’s Withdrawal Agreement will be rejected by the UK Parliament in December. Thereafter, she will bet that MPs will face criticism from local constituents over the Christmas recess, and be persuaded to change their minds when the Agreement is put to a second vote in January. I suspect it will then pass, but am not sure Why! If not, economic risks will escalate before and after 29 March.

• Italy: Italy’s submission, and subsequent rejection by the European Commission, of a budget proposal producing an unsustainable debt trajectory rightly gathers the headlines. I expect that many months will pass before a compromise is reached. The Italian coalition will wait until after the May European elections hoping that further populist gains will force EU concessions.

What is lost in the current debate, however, is that only structural reforms aimed at remedying Italy’s miserable productivity track record will deliver the rising living standards, jobs, and debt stabilisation the Italian electorate seeks and deserves. I am not optimistic.

• Germany: A poor showing by Chancellor Merkel’s coalition partners in May Euro elections will likely bring an early end to her premiership.
• France: President Macron’s reforms are producing results, albeit limited.  However, his program, which will need to be deepened eventually, is already unpopular in some circles (witness this weekend’s reaction to lower energy subsidies). Without a successful domestic agenda, he will be unable to provide the leadership required to implement EU-wide pro-growth reforms. Again, it’s hard to be optimistic, especially in light of Chancellor Merkel’s weakened status. Weak European growth and high unemployment are likely to produce further populists gains in the May elections.

Strategic Implications

• Europe will not slip into recession. In fact, European growth will advance an above-trend 2% next year following a 1.9% gain in 2018. Stimulative monetary and fiscal policies and a rebound in the auto sector will offset political risks.
• As the US economy slows in 2019, the divergence in economic performance will narrow.
• The ECB will end QE in January. A September 2019 rate hike still looks like a good bet. This decision could be delayed if weak economic growth persists.
• The US dollar will appreciate until the gap in economic performance and monetary policy narrows  in H2 2019.
• Easy money, low inflation, superior EPS growth, cheaper valuations, and eventually a weaker USD should help European equity markets to outperform.
• Europe’s challenges (and risks to the Euro’s future) will intensify in 2020 when the combination of rising interest rates and weak GDP growth threaten the region’s vulnerable public sector debt dynamics.