Macro Weekly – Weakness in Europe is exaggerated, expect a bounce

by: Han de Jong

  • Recent weakness in confidence and hard data in Europe will prove temporary
  • Asian trade picks up in March
  • US inflation remains well-behaved
  • Markets remain sensitive to Trump tweets
180413-Macro-Weekly.pdf (272 KB)

This year is turning out to be very different from 2017. Economic momentum rose beyond expectation in the eurozone last year while the Asian economies also performed better than expected. At the same time, growth in the US was ‘only’ in line with expectations. So far this year, it is the other way around. Economic momentum in the eurozone and Asia has softened noticeably in recent months, while the US is holding up better and growth forecasts for the US have been revised higher. The question is what we should read into this different relative cyclical pattern. Not all that much, in my opinion, but it needs watching.

What is wrong with Europe?

Why would Europe now be weakening as suggested by a remarkably wide range of confidence indicators and, increasingly, harder data? Recent data on industrial production, for example, was not at all encouraging. Eurozone industrial production fell 0.8% mom in February, the third consecutive monthly drop. The year-on-year growth rate has fallen from a recent peak of 5.8% to 2.9%, Germany drop was even more pronounced: from 6.3% yoy to 2.6%. It would be seriously worrying if this trend continued. Will it? I don’t think so.

The big drivers have not turned restrictive

We must first address the question what is behind this weakening of the business cycle in the eurozone. It is not so obvious. The big drives provide no explanation. Fiscal policy has not been tightened suddenly. In fact, if anything, fiscal policy is gradually being loosened. Monetary policy is obviously also still highly accommodative. The exchange rate of the euro may explain some of the cyclical softening. The currency turned higher early in 2017. The tailwind that the previously weakening euro had provided thus gradually disappeared in the course of last year. The tailwind may even have turned into a mild headwind, but this should not be sufficient to do a lot of cyclical damage.

External impulses are another possible explanation for the weakness in confidence and in actual activity. The US is not likely as a source of weakness as its economy continues to growth at a decent clip. The impulse from Asia, and in particular China is a more likely culprit. China’s policymakers have shifted from providing stimulus to targeted tightening. This is slowing the economy and Europe is possibly more sensitive to the Chinese business cycle than the US is. It looks unlikely to us that Chinese policymakers will allow their economy to lose a lot of momentum suddenly.

Smaller reasons

Other reasons for the softening in Europe may simply be that growth was significantly above trend and that was never going to be sustainable for a long time. Confidence indices in particular, were at extremely high levels and may have adjusted to more realistic levels. In addition, anecdotal evidence suggests that there is an increasing number of pockets where bottlenecks are hindering growth due to a lack of qualified labour. At the aggregate level, though, it is hard to believe such bottlenecks are so widespread that they should limit overall growth significantly.

Winter weather, the flu, strikes and Chinese New Year

If these sort of factors do not provide sufficient explanation for the weakness in eurozone confidence and in the business cycle in general, one must consider whether or not the data has been distorted or temporarily affected by one-off developments. In that case, the recent weakness would be largely noise. I think this is most likely the case. Three recent developments may have had a negative, but temporary, impact on eurozone activity levels. In random order: the weather, the flu and strikes. Some eurozone countries have been hit by a couple of bouts of severe winter weather in Q1. The flu may have also played a role. A larger number of people than normal has been hit by the flu this season and the epidemic is also more severe than, for example, in the US as the WHO graph shows. Last, recent months have seen a surge in strike action in the eurozone. The weather will obviously improve, the flu epidemic is abating, but strikes may continue.

Asian March trade data extremely encouraging

Another distortion may come from Asia. This is something I have highlighted often before. Chinese New Year moves around in the regular calendar. This makes reading the tea leaves of the Asia economies in January and February very hard. So what is important is to see what happens after January and February. The March data, as far as is available, is extremely encouraging. The first indication was provided two weeks ago by data on Korean exports during the first 20 days of March. More recently, this was confirmed by export data from Taiwan. Taiwanese exports were up 16.7% yoy in March, representing a material recovery from February’s -1.2%. Chinese data was also recently released. Import growth (in USD) moved up from the Lunar New Year depressed February level of 6.1% to 14.4% in March. This was bang in line with the pace seen in the second half of last year and suggests there is no meaningful deterioration of the Chinese cycle that should be expected to hit the eurozone economy.


This also applies to the trade flows of Germany. German statisticians work much more slowly than their Chinese counterparts, so for the most up to date German trade data, one must look at Chinese data. German exports to China (in USD) fell a shocking 25% mom in February according to Chinese statistics. But they rebounded by 34% in March, pushing them 1.5% above the January level. German statisticians have only just released February trade data. They show a decline in overall exports of 3.2% mom. No doubt, this has affected business survey indicators such as Ifo. The Ifo index of business confidence fell exceptionally sharply in February and extended these losses in March. However, the Chinese data suggests that the picture will be very different in the months ahead.


Shopping spree in Hong Kong

It is clear that we do remain dependent on the Chinese cycle. How fast that economy slows, remains an important variable. It has long been our view that the process of slowing will be gradual in China. An indicator that recently caught my eye is Hong Kong retail sales. They were extremely strong in February. This is also likely related to Chinese New year. It would appear that many Chinese (from Hong Kong itself, but visitors from the mainland as well, went on a shopping spree during their New Year holidays. Such data ties in with the extremely strong level of Chinese consumer confidence. This may be one more indicator supporting the view that the Chinese economy is not falling off a cliff.

I am convinced the data is seriously exaggerating, expect a bounce

On balance, I am convinced that the sharp deterioration in business confidence and hard data in the eurozone in recent months is a sharp exaggeration of what is going on. Admitted, growth may be past its peak, but recent indicators paint a picture that is far too negative. There simply aren’t sufficient explanatory factors to suggest the recent developments represent a trend that will be sustained. I think factors such as the weather, the flu and distortions related the Chinese New Year are the driving forces. The most recent trade data from Asia strongly supports my optimistic view. If I am right, not only should we soon see better hard data from the eurozone, but confidence indices should also bounce back, at least to some extent.

Geopolitical tension, including the trade conflict, can, of course, still be a negative. No doubt, the escalation of the trade conflict has also been a negative factor for business confidence. It is impossible for us to say which way the trade conflict will go, but our base case remains that it is unlikely to go completely out of control as there is too much to lose for all involved.

US inflation well behaved in March

Worries over US inflation spooked financial markets earlier in the year. We never subscribed to the view that US inflation would rise significantly. It was always our view that inflation would move higher in 2018, but at a modest pace. Recent months have challenged that view as significant increases occurred. Looking at the detailed data at that time, we still concluded that inflation was being pushed up by temporary factors. Two main culprits in recent months were motor insurance and apparel. The March data suggested that our assessment was correct. The rise in motor insurance slowed significantly in March and after rising by 1.7% and 1.5% mom in January and February, apparel prices fell 0.6% mom in March. The headline CPI actually fell 0.1% mom. Core CPI moved up by just under 0.2% mom. Due to base effects, core CPI inflation rose from 1.8% to 2.1% yoy. Nevertheless, we feel comfortable with our US inflation outlook and we think there is little reason for the Fed to hike more aggressively than currently indicated. Having said that, we have changed our view on the number of rate hikes the Fed will deliver this year, moving from two more hikes to three. The reason is remarks by various FOMC members who appear more inclined to move to a ‘normal’ policy at a steady pace. Hiking once a quarter seems a good pace.