Friday, February 27, 2015

A pronounced cyclical Eurozone upswing is in the offing

The structural factors holding back the Eurozone remain substantial, most notably poor demographics, high indebtedness and a lack of reforms in large countries such as France and to a lesser extent Italy. These structural deficiencies are mainly responsible for relatively low trend growth, probably close to around 1.5%. On the other side, cyclical forces are about to provide the strongest aggregate growth support in a long time. As a result, Eurozone growth should increase markedly in the quarters ahead, likely moving to around 2.5% on an annualised basis by year-end.
First, oil prices in Euro have collapsed and are now down by approx. a third since June last year. It is thought that a 10% drop in oil prices reduces the CPI index by approx. 0.2% and might increase GDP by 0.3%. However, the effects on inflation have largely run their course after three months while it takes 3-4 quarters before the effects on growth become visible. Hence, oil prices are only just about to start exerting their growth positive impetus with the support becoming ever stronger as the year progresses.
Second, the Euro has appreciated since the summer of 2012 until reaching a high in between Dec13 and March14 before moving slightly lower during summer and sharply lower from December onwards. Changes in the trade-weighted currency usually take around 6-9 months before they are being reflected in the economy. Hence, so far only the growth negative effects of the previous strong Euro period should have been absorbed. The growth positive effects of the subsequent Euro weakening are just about to begin and should also become stronger as the year progresses.
The collapse of oil prices (in Euro, red) and the fall in the trade-weighted Euro (white) will exert a growth positive effect
Source: Bloomberg
Third, real yields have moved sharply lower. 10y German real yields have already from 2009 started to become growth supportive as they fell from 2% in 2008 to below 1% in 2011 and have traded below 0% for most of the time since 2012. On the other side, peripheral real yields have been at historically high levels during recent years, thereby exerting a growth negative effect on the economy. As an example, 10y BTP real yields increased from approx. 2.5% in 2008 to 7% in late 2011, before starting to fall as the ECB implemented its emergency measures. Still, even at the beginning of last year, 10y Italian real yields hovered around 3%, a substantially restrictive level for a country where trend growth stands around 0.5%. By now, though, real yields have fallen to approx. 0.3% and should thus provide for an increasing growth tailwind. 
10y BTP real yields (left) have become growth supportive
Source: Bloomberg 
Fourth, credit creation has been negative ever since the Eurozone sovereign crisis broke out in 2011. The right-hand chart below shows the yoy growth rate of MFI loans to the private sector. Loan growth peaked in 2011 when the Eurozone debt crisis broke out and moved into negative territory. Negative loan growth became even more pronounced during 2013 as banks prepared for the ECB’s comprehensive assessment (as the end 2013 balance sheets were used for the AQR). However, loan growth has bottomed a year ago and has slowly recovered since. The outstanding level of loans has bottomed in August last year, just ahead of the release of the AQR results. In between September 2011 and August 2014, loans were reduced by a total of EUR 670bn, which also constituted a significant drag on the economy. Looking ahead, though, the banking sector has been largely recapitalised and the new single supervisory mechanism (SSM) is now in place. Banks are thus finally in a position to more actively manage their balance sheets while improving growth coupled with lower loan rates – substantially so in the periphery – suggests that loan demand should pick up again. Hence, credit creation promises to move back into positive territory, thereby also turning from a growth headwind to a tailwind. 
Credit creation has bottomed
Source: Bloomberg 
As a result, monetary policy has finally become accommodative for the periphery for the first time since the Eurozone debt crisis broke out in 2011. Moreover, fiscal policy has been a significant drag on growth in recent years amid large scale austerity measures. According to the IMF, the cyclically adjusted primary balance for the Eurozone has moved from a deficit of 2.5% in 2010 to a surplus of 1.2% in 2014. Hence, fiscal policy has accounted for a drag of approx. 4% of GDP or 1% per year in recent years. However, the austerity drive has weakened during recent quarters and fiscal policy has moved from being very restrictive to becoming only mildly so and thus the growth negative impact should be much smaller as well.
On a country basis, Germany should continue to do well amid growing exports and a supportive backdrop for the domestic economy (low real yields, high employment, rising real wages). More importantly, France and Italy promise to move from below trend to above trend growth by the end of next year. The substantially weaker Euro should be of vital importance for these countries exporters given that they mainly compete via price and less via product complexity/quality such as for example Germany. In the case of Italy, the sharp drop in nominal and real yields should also provide for relatively higher support.  
Summing up, monetary policy as well as oil price and exchange rate developments turn from a significant growth negative factor towards a marked growth positive one while the growth negative impetus of fiscal policy abates. Therefore, Eurozone growth should move from a below trend pace to a markedly above trend one of around 2.5% on an annualised basis towards year-end. As growth improves, so should the long-run trajectories for the debt-GDP ratios across the Eurozone. The structural primary balances have mostly moved into surplus already and fiscal deficits should become significantly lower amid higher growth and lower yields. Markets should increasingly focus on these materially improving Eurozone growth prospects.