Europe – clouds gathering over growth outlook

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This post is a guest contribution by Elga Bartsch, Daniele Antonucci, Olivier Bizimana, Anselm Karitter and Tomasz Pietrzak of Morgan Stanley.

We are cutting our GDP estimates for 2012 by half a point, at the same time we are raising 2011 a bit. On the back of earlier-than-expected ECB rate increases and a higher-than-expected exchange rate, we are cutting our 2012 GDP forecast from 1.7% to 1.2%. At the same time, the stronger-than-expected momentum in the first few months of this year causes us to raise our 2011 estimate from 1.5% to 1.7%. Contrary to our previous forecasts and the current consensus estimates, we are now looking for a deceleration in the growth momentum, not a small acceleration. The forecast change puts us meaningfully below the consensus for next year, which still sits at 1.7%, and makes us the most bearish house on the Street.

More than the absolute numbers we are forecasting, we would stress the change in direction for growth. In our view, we could be close to a turning point in the forecasting cycle. We would expect more forecasters to start to bring down their 2012 numbers in the coming months. Such a turnaround in the forecasting cycle, where until now forecast revisions were only on the upside, likely matters more to investors than the point estimates. More forecasters bringing down their estimates will likely trigger a debate on the sustainability of the euro area recovery, thus creating fresh headwinds for risk assets in 2H. This would reinforce the view of our equity strategy team that European equity markets will likely experience a more difficult second half this year. Similarly, our credit strategy team would dial down the exposure to high yield credit in the face of ECB rate hikes and instead stay close to selective investment grade names.

The main reason for us lowering our 2012 forecasts is the combination of early ECB rate hikes and a stronger appreciation in the euro this year. We had changed our view on the ECB and the euro in early March on the back of the surprisingly hawkish ECB press conference in which ECB President Trichet strongly hinted at the Governing Council being willing to pull the trigger at the April meeting. At the time, we changed our ECB call from no rate hike this year to 75bp before year-end. This unprecedented step in which the ECB, for the first time ever, will hike interest rates before the Federal Reserve (something that even the Bundesbank never dared) caused our FX team to nudge its euro forecasts up markedly. Neither of these two changes was yet incorporated in our baseline forecasts. In addition, we had to incorporate the latest upward move in the price of oil. Modeling the impact of these changes in the assumptions underlying our forecasts, we estimate the impact to be felt most strongly in late 2011 and early 2012. In addition, the global economics team was re-running their forecasts to incorporate the latest policy actions, commodity price movements and the recent events in Japan.

Both domestic demand and export dynamics hit. The downward revision in our headline GDP forecast in 2012 largely stems from the expected deceleration in the dynamics in late 2011 and early 2012. The delayed impact is due to the time lags with which changes in interest rates and the currency typically affect economic activity. While the euro obviously is primarily working through the growth contribution of net exports, the higher interest rates are primarily affecting domestic demand (notably investment spending). To a lesser degree, we expect negative repercussions for consumer spending growth. But clearly consumer spending growth is already being hit by fiscal austerity and higher commodity prices (including oil prices).

Thus far, the impact of the events in Japan on Europe has been relatively muted in terms of direct economic linkages. It is important to bear in mind that Japan only takes 2.2% of the euro area exports and the euro area only buys 3.3% of its imports in Japan. If anything, the incoming activity data that we keep feeding into our GDP indicators are still pointing to small upside risks to our 1Q GDP estimate, even after we raise our estimate from 0.4%Q to 0.6%Q (or from 1.6% to 2.3% in annualised terms). Even the potential supply chain disruptions seem to be smaller than initially feared. Hence, the main impact of the events in Japan on Europe might eventually be that several governments are rethinking their energy policy, something that could potentially exacerbate the impact of the current commodity price shock – e.g., in Germany where the government has imposed a moratorium on its nuclear power stations.

In our view, the inflation outlook in the euro area remains a relatively benign one over the medium term. On our forecasts, headline inflation will likely average 2.3% this year but then ease back to 1.8% next year. Core inflation pressures are likely to remain subdued, given the muted increase in unit labour costs we are forecasting. In our view, companies still have very limited pricing power and trade unions in the euro area still have limited bargaining power. True, there are some exceptions, notably in Germany, but these exceptions tend to be for sectors with considerable international exposure and strong productivity gains rather than domestic service-oriented sectors. With monthly headline inflation numbers likely to ease back to low readings such as 1.5% in the middle of next year, on our forecasts, we believe that the ECB is likely to decide to put its tightening campaign on hold for a while at that time.

ECB likely to pause its tightening cycle in 2012. Against the backdrop of a renewed deceleration in growth and an inflation rate that is back below the price stability ceiling, we expect the ECB to pause its tightening campaign in the spring of 2012. Until then, however, we expect the ECB to raise the refi rate by a total of 100bp, starting with a first move at the April Governing Council meeting. Initially, we believe the main motivation for the ECB’s desire to tighten monetary policy is to remove the emergency element from the extremely low level of its official policy rate at present. Our 2011 forecast is very close to what the money markets are pricing in for the ECB policy action. Only once the refi rate is back at around 2% is the ECB is likely to become more data-dependent again. At this stage, we expect the bank to acknowledge the dip in growth and hit the pause button. With the ECB in tightening mode for the next 12 months, we also see government bond yields moving higher and expect 10-year Bund yields to rise towards 3.75% by next spring. This compares to a current yield for 10-year Bunds of 3.4%. Like our interest rate strategy team, we think that two-year yields have further to rise, causing the 2-10s curve to flatten but still stay steeper than it has done historically in a tightening cycle.

Peripheral pain likely to rise further once growth loses momentum. A renewed deceleration in growth across the euro area will likely cause additional pressure in the periphery, we think. Slower growth will make it even harder for Finance Ministers to achieve their ambitious budget targets, be it within strict IMF/EU adjustment programmes (Greece, Ireland) or under the Stability and Growth Pact commitments. Further, fiscal stabilisers are unlikely to be allowed to adjust fully to cushion against the impact of slower growth, given that public finances are already under severe pressure. Finally, higher interest rates and bond yields in the core could also contribute to funding pressures in the periphery.

To get an idea of the country impact of the combination of early ECB rate hikes and a stronger euro, we looked at the macroeconometric models developed by the central banks that – together with the ECB – form the Eurosystem and hence are estimated in a consistent, like-for-like fashion. We feed these models with two different shocks: an ECB rate increase by 100bp and an appreciation of the euro by 10% in trade-weighted terms. Note that these estimates are only providing some broad-brush guidance. As such, the models are only one factor that we take into consideration when running our forecasts for the individual euro area countries.

The countries that are further to the left and further to the bottom in Exhibit 5 in the full report will be hit harder by higher ECB rates and a stronger euro. Note that the shocks are estimated separately so, to get the impact of a combined shock, we need to add up the values depicted in the chart; e.g., for the euro area the total impact would be -0.9% (of which 0.22% is the impact of the higher rates and 0.7% is the impact of the stronger euro). This provides only a very crude approximation though, given that these developments are usually not additive.

We find that France, Belgium and, surprisingly, Portugal, have historically been more resilient than the euro area average to these two shocks. The closer a country is positioned to the upper right hand corner, the more ‘bullet-proof’ it is against these shocks. In Portugal, however, this largely seems to be a timing issue for after two years, Portugal feels the impact of an ECB rate hike much more than the euro area average. This is what one would expect, given the elevated level of leverage in the private sector in Portugal and the widespread use of variable rate mortgages.

Vice versa, Germany, Greece and Finland have been more sensitive than the euro area average to changes in interest rates and exchange rates. For Germany and Finland, this will likely be a reflection of their large industrial sector and specialisations in cyclical sectors. At the current juncture, both countries should benefit from their underlying strength and the improvements in cost-competitiveness over the last few years.  Germany is one of the countries for which we forecast a rather steep deceleration in growth, from 2.6% to 1.6% over 2011/12.

Finally, several countries – including Spain and Italy – are very close to the euro area in terms of their sensitivity to these two shocks. For Italy, this is largely a timing issue as Italy will start to feel the impact of higher interest rates much more after two years. Spain, however, at least historically also after year two is still close to the average impact on the euro area. These estimates for Spain are encouraging and would seem to support our view that Spain is different to other peripheral countries. We would caution though that the Spanish economy today is much more leveraged than it was during the time period in which these models have been estimated, and variable-rate mortgages now account for 90% of mortgages.

Last but not least, we would highlight that Ireland is less sensitive to euro gyrations than the euro area as a whole. While it is not much more sensitive to interest rate changes in the first year, it also feels more of a pinch in year two. In addition, the same caveats for Spain also apply to Ireland. One difference though is that variable-rate mortgages only account for 67% of the housing debt and Irish banks already started to raise mortgage interest rates a year ago despite the policy rate still being unchanged at 1%.

Source: Morgan Stanley, April 11, 2011.

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