Macro Weekly – Moments of truth approaching

by: Han de Jong

  • German soft patch continues, as
  • Chinese import growth surges, and
  • The ECB prepares to exit
  • But factors were in place for sizeable correction at some stage
180608-Macro-Weekly-1.pdf (248 KB)

The softness of business confidence and harder economic data in the eurozone and particularly in Germany has been one of the main economic surprises this year. I first thought it was just noise, as I failed to see what should be causing a sustained period of weakness. Of course, I recognised that this was softening from a high, so we were not talking about an actual downturn in the economy, just a slowdown from a rapid pace of growth, but still… When the ‘noise’ did not stop, I blamed temporary factors. But as their influence should have abated, the softness continued, forcing me to think up some other theories. My current theory is that the weakness is the result of a combination of factors: China, the trade conflict and perhaps the shortage of labour. The rise of the euro over the last eighteen months and the higher oil prices have not helped either.

If you have a theory, you must try to find data to confirm or reject it. In the case of China’s alleged impact on the European business cycle, the thinking is that short-term fluctuations in Chinese international trade have a material impact on the economies of China’s trade partners. International trade data clearly shows that world trade growth slowed materially early this year, which is  confirmed by the CPB’s data on world trade growth and, last but not least, by European data. Eurozone Q1 GDP data, for example, shows that domestic demand expanded at a healthy enough pace and that the slowdown was due to the international trade sector.

Another poor set of industrial data in Germany

On the positive side, trade data in Asia appears to have improved a little after March. For my theory to be correct, this should translate in an improvement in economic conditions in the eurozone. Unfortunately, that isn’t happening yet. Recent trading days have seen another set of hugely disappointing German data. Factory orders fell a stiff 2.5% mom in April, after a drop of 1.1% in March. It was the fourth consecutive monthly decline. The yoy rate of growth fell back to -0.1%. Domestic orders were down 4.8%, foreign orders 0.8%. Very disappointing was the strong drop of orders for capital goods: 5.8% in the case of domestic orders, 5.4% in the case of foreign orders.

The data on industrial production were also disappointing. Output fell 1.0% mom, although the rise of March was revised from +1.0% to +1.7%. The yoy rate has now slowed to 2.0%, down from 3.8% in March. For what it is worth, the German data is, surprisingly, a lot weaker than the Dutch data on industrial output. Dutch manufacturing production rose 0.6% mom in April and 5.0% yoy. German export data for April wasn’t uplifting either. Exports fell 0.3% mom, though March had seen a 1.7% mom rise.

Not all news is bad, of course. The German retail PMI bounced back up in May: 55.5, versus 51.0 in April. And the construction PMI improved from 50.9 in April to 53.9.

But here is the good news

Korea had already released positive May trade data earlier. The better trend was confirmed by the Chinese trade data. Export growth (in USD) stabilised at 12.6% in May. More importantly, Chinese imports were up an impressive 26.0% yoy in May, following 21.5% in April. These numbers may have been flattered by higher oil prices or even exchange rate movements, but they still look healthy. If my theory is correct, the European data must soon reflect the improvements here. So the moment of truth for this theory is approaching rapidly. To be frank we should soon see a significant improvement in eurozone and German confidence indicators as well as hard data. If that improvement does not materialise we will need seriously to reconsider the near-term growth outlook.

The ongoing trade conflict is another possible explanation for eurozone, and in particular German weakness. The idea is that the uncertainty created by the trade conflict is damaging confidence and forcing businesses to postpone their investment spending plans. I find this line of thinking not fully convincing. True, uncertainty may damage confidence. Particularly, German business confidence may be hurt by the US investigation into whether or not the import of foreign cars into the US is a threat of US national security. But for this uncertainty also and already to have had a significant impact on the actual levels of economic activity is a different matter. On this point, too, the moment of truth is approaching: will the Trump administration back down from its aggressive trade rhetoric or not?

Moment of truth for the ECB also

The ECB is likely to make announcements at their next policy meeting about the exit from the QE programme. So far, the line has been that the ECB will only quit the programme if it looks like inflation will be heading towards the 2%. The last set of inflation data shows that inflation has suddenly turned up. However, that looks to be the result of incidental factors and the rise of oil prices. Following the logic the ECB has been communicating, that would not be enough for an early end to asset purchases altogether and for interest rates to be lifted.

In a remarkable speech, the ECB’s chief economist, Peter Praet, who has been one of the more dovish ECB officials, seems to have done a bit of a U-turn. He said that the upcoming meeting will be a decision moment and that the criteria for ending the programme have been met. We are somewhat surprised by his speech because of his earlier dovish tone and the fact that the eurozone economy has hit a soft patch, which we cannot be sure is temporary. In addition, we doubt if inflation will move up to 2% on a sustainable basis any time soon. Not that I think there is a problem with inflation at its current level, but the ECB, and Praet in particular, have stressed the importance of the 2% so much. We will see. Following Praet’s speech, markets adjusted their expectations. This may have further to run.