Tyndall Monthly Commentary: Eurozone crisis far from over

The economic situation in Europe has been out of the headlines but data from the region suggests the real economy hasn't improved and the crisis will be back in investors' minds before long.

Monday, March 4th 2013, 3:30PM

by Andrew Hunt

Over recent months, there has been a rush amongst politicians and even in the press to once again proclaim that the Euro Crisis is over. This latest bout of optimism has been based primarily on the fact that bond “spreads” between the debt markets of the periphery and the core countries of Europe have narrowed substantially over recent months. Particularly since the European Central Bank’s Chairman, M. Draghi, overrode some of the concerns of his own board members and advisors and announced that he would do whatever was necessary to save the Euro – including “unlimited asset purchases”.

In fact, we find that M. Draghi and his newly revived ECB has not had to do very much since his now-famous verbal intervention on the way to his guest seats at the Olympics in London; his words have apparently been enough on their own to lead foreign investors to commit record amounts to the peripheral Eurozone government bond markets with the result that bond prices in these countries have rallied without the need for ECB physical intervention. The ECB has found that it has needed to lend less rather than more to the periphery and its banking systems and financial markets in general have come to view the Eurozone economies as being on the road to recovery.

Unfortunately, we can see little to justify the surprisingly common view that the Eurozone crisis is now over and that the economies are somehow on the road to recovery. For example, even within the supposedly strong man of Europe, Germany, we find that although the rather subjective business confidence indices (as measured by the widely watched ifo and PMI surveys) have generally picked up, the actual production, income and spending data has remained very weak. Admittedly, the domestic industrial orders data did pick up in Germany last month but we find that this was primarily due to a one-time surge in orders for electricity generating equipment that was associated with the building of a new power generation plant – not something that happens every month. Excluding this “special factor”, German trends in general remain very weak: industrial production has fallen by 1.9% over the last three months, German household disposable incomes and borrowing are falling in real inflation-adjusted terms and, most worryingly of all, we find that retail expenditure has fallen at a 6% annualised rate over the last three months in volume terms.

At first sight, it would seem difficult to reconcile this seemingly very weak data with the recent increase in reported industrial confidence but we should note that German business confidence routinely tends to pick up in the December-February period, before declining thereafter. One might suspect that this is simply a problem with the seasonal adjustment factors (not an impossible scenario given the timing of the GFC and subsequent economic slump in 2009) but we should also note that the rise in the confidence indices this year has once again not been the result of an improvement in “actual business conditions experienced by your company” but rather the result of an improvement in companies’ expectations for the future.

In effect, it seems that German industrialists are forecasting an improvement in the economy at present rather than experiencing one and, as we infer in the chart, this somewhat non-stereotypical behaviour is quite usual for German executives; they appear to begin the year expecting things to get better, even if reality turns out to be somewhat different. Certainly, the German corporate sector’s expectations for 2012 turned out to be somewhat better than the reality of the situation and we may find that the same occurs once again in 2013.

Elsewhere in the Eurozone, meanwhile, we find that the bulk of the recent economic data has been even weaker than that in Germany, with France, in particular, suffering a notable deterioration in experienced business conditions that suggests that the Euro Economic Crisis may be drifting northwards. Certainly, we find the recent collapse in French business confidence, the weak consumer situation and the recent outbreak of house price deflation a cause for concern.

Italy’s data has also started to look quite concerning – albeit not quite so unexpectedly. Italian industrial output dived 2% QoQ in the fourth quarter of the year and, more worryingly still, the latest new orders data seems to be indicating an accelerating pace of decline for the first quarter (more or less across the board at a sector level). The Italian fourth-quarter employment data was similarly soft and the available business surveys for January have all been very weak indeed. Certainly, the industrial and retail surveys looked “GFC-like” in their behaviour and although the service sector index bounced slightly, it was a modest bounce from an extremely low level.

It is in Spain (which has yet to properly report its Q4 GDP data), though, that the worst data has appeared. We have long noted that debt deflation is a reality in the economy but the weakness that has been present within the latest slew of official data has surprised even us. Fourth quarter industrial production was down 1.6% QoQ, which clearly is a worrying number (albeit one in line with elsewhere in the region) but, more worryingly still, we find that retail sector turnover was down by a massive 6% QoQ (25% annualised!) according to Eurostat and retail volumes according to Spain’s own data seem to be off 10-12% YoY. The various business surveys that are available also pointed to similar degrees of woe.

At a micro level, we have heard from freight companies and even cash-collection companies reporting sales down by a fifth year-on-year (the unrecorded “black economy” seems to be suffering just as much as the official sectors) and we have been struck by some of the corporate data emerging from the economy. For example, the MH Hotel Group (a predominantly business-traveller-hotel chain) has suffered a 97% decline in earnings before interest, tax and depreciation in the first nine months of the year and its guidance for the fourth quarter suggested that things had deteriorated even further as the year drew to a close. Sales and occupancy rates were down heavily but significantly the company was also unable to reduce even its variable costs despite its dire situation. We have no idea whether MH is a good, bad or indifferent company, but its results seem to gel with the trend in the macro data that we are seeing and, if this is the case, then Spain may be falling into the same economic black hole that has befallen Greece over recent years. Though, Spain’s economy is somewhat larger than that of Greece.

If this is indeed what is occurring within Spain’s economy, then it would explain why Spain’s banks have recently begun to divest (albeit quite modestly so far according to the newly revised data) from the local bond markets. If Spain’s nominal economy is contracting at potentially a double-digit rate, then we can safely assume that the budget deficit will be expanding, bad debts rising and political disquiet growing (aside from recent scandals) and these would all seem to be good reasons for Spain’s banks – who probably have a better feel for the true state of the economy than anyone else at present given the country’s rather tardy release of economic data – to begin seeking safety outside the local bond markets.

At present, Spain’s bond market and indeed its balance of payments is being sustained by record levels of large capital inflows (the improved current account situation so beloved by the sell-side analysts has been an almost insignificant part of Spain’s BoP improvement over recent months), but if a new phase in the Spanish political/economic crisis unfolds as expected – and the Spanish banks seem to be betting on this already – then these current record capital inflows may yet turn around and become record outflows once again, with all that that would entail for investor sentiment and Spain’s balance of payments position.

Given these real economic and even financial trends within the Euro system, we suspect that at some point this year the Euro crisis will re-emerge at the forefront of investors’ minds. This re-emergence may not yet be imminent (even if Mr Berlusconi does indeed succeed in completing a remarkable political comeback) but once the true extent and implications of the economic weakness in Europe become apparent and the weather warms up enough to encourage protestors back onto the streets, we suspect that financial markets will face another Euro-related “speed bump”.

Until this point, though, the continued and significant liquidity injections from the US Federal Reserve and the Bank of Japan’s measures to support their bond market (albeit panicked) may keep risk assets well bid. For market timers, 2013 promises therefore to be no easier than was 2012 or 2011 but at least it has started on a positive note that may persist for a few more weeks before Europe’s travails reassert themselves, for a while at least.

Andrew Hunt
International Economist, London

Andrew Hunt International Economist London

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