I’ve previously argued that likely weak credit and labour market dynamics pose downside risks to the nascent Euro Area recovery. And Friday’s Q2 GDP data were disappointing at both the aggregate and country level, adding to other recent weak/mixed data. Given the ECB’s unprecedented monetary stimulus, support to real incomes from lower oil price and nascent net export boost from the weaker euro this raises further issues about whether the EA economy will respond to the medicine or is rather suffering from something more deep-rooted (e.g. Draghi’s exhortions to governments to pursue structural reforms). On top of that the EUR is currently being supported by risk-aversion effects related to the PBOC’s shock announcement last week. Should that persist or extend, the ECB’s preparedness to tweak QE evident in last week’s ECB minutes will likely move a step closer. So the 3 September ECB meeting, when they will have updated staff projections, could potentially be a little more interesting than the past couple of months (although my central case is not to expect that much).
Weak EA GDP (and other) data
The +0.3% qoq EA growth was below the +0.4% market consensus and Q1’s +0.4%. At a country level France’s 0.0% qoq looks the most worrying – with consumption (+0.1% qoq), investment (+0.2% qoq) and industrial output (-0.1% qoq) all weak – causing further doubts about president Hollande’s ability to turn the underperformance around (although the Q1 figure was revised up). Italy’s +0.2% qoq figure was slightly better, although we don’t know much about the composition beyond services output being apparently flat (with some growth in industry and agriculture). But Dutch +0.1% growth also undershot the +0.3% expected. And Germany’s +0.4% disappointed expectations of +0.5%, with (construction) investment and inventories reportedly weak and net exports sounding like the biggest driver helped by the euro’s fall (while household and government consumption “continued to develop positively”). The main upside was Spain’s continued relative strength (+1.0% qoq), mirroring the outperformance in the PMIs, continuing its role as poster child of economic reform. Greece’s very surprising +0.8 qoq could reflect the Greek people trying to accumulate real assets given fears of banking sector meltdown (although upwards back revisions are harder to rationalise).
Moreover, industrial production again undershot market expectations last week – falling month-on-month for the third time in four months. The July ECB minutes somewhat shrugged off May’s fall, in part based upon potential data volatility, so the latest fall could raise the level of alert. That said, the minutes also took solace in the uptick in the ECB survey of industrial new orders. And that has subsequently picked up further, to its highest since July 2008 (see chart) driven by non-domestic and capital goods orders (with domestic orders and consumer and intermediate goods orders flatter). German factory orders also rose 2.0% in June, on the back of a 4.8% rise in foreign orders that could be linked to the Paris air show. So there are reasons to be cautious about excessive gloom. But some positive hard data would nevertheless help assuage concerns – which last weeks’ sharp decline in the German ZEW survey’s expectation component fuel.
And let’s not forget that EA retail sales substantially disappointed on 5 August (-0.6% mom) with German sales particularly weak (-2.8% mom). And while the final services and composite PMI’s release the same day were revised up from the preliminary data they nevertheless fell on the month (as did the manufacturing PMI), again suggesting faltering growth dynamics.
EUR appreciation unhelpful
Last week’s ECB’s minutes seemed most concerned about the potential fragility of net exports due to “possible reversal of recent energy price and exchange rate developments” (i.e. EUR bouncing back) and “lower than expected global trade growth. In particular, financial developments in China could have a larger than expected adverse impact, given this country’s prominent role in global trade. This risk could be compounded by negative knock-on effects from interest rate increases in the United States on growth in EMEs”. So last week’s PBOC shocker, which I discuss in an accompanying post, will have particularly concerned the ECB – both by raising concerns about Chinese growth/trade prospects and by pushing the euro up.
In particular, EURUSD has risen back above 1.11 despite EA-US 2y swap rate differentials, the usual driver of near-term EURUSD moves, suggesting a depreciation (driven e.g. by Thursday’s strong US retail sales and Friday’s above-consensus US industrial production). As I’ve discussed previously that reflects EUR being supported by elevated market risk aversion, given its post-ECB QE role as a funding currency, this time driven by the PBOC’s shock announcement (global equities fell as a consequence). Moreover, the EUR TWI has risen more strongly (by 3.2% since its mid-July low-point) helped by the rise in USDCNY after the PBOC announcement and given that CNY has a 22% weight in the ECB’s EUR TWI.
And it’s notable that despite the euro’s fall thus far net exports have not supported EA GDP (indeed they knocked 0.2pp off growth in Q1). The euro’s recent rise will likely not help that situation – it runs counter to the ECB’s hope that improved competitiveness will support net exports. Moreover, the German FSO’s statement last week that in Q2 the weaker euro was helping support German exports has yet to be mirrored in other EA countries and Germany is more exposed to a Chinese slowdown than other EA members.
A further notable thing in the ECB minutes was that, mirroring Draghi’s press conference comments, they were sanguine about EA inflation expectations, arguing “Survey and market-based measures of inflation expectations had risen since the start of the year and had stabilised or recovered further since early June.” But the concern I noted in my previous post about EA 5y5y breakevens heading back down with the continued fall in oil prices (itself in part due to the PBOC’s announcement) has become more apparent in the intervening two weeks. And as the ECB minutes noted “market-based measures of inflation expectations at shorter horizons were still considerably lower than at longer horizons”: 5y breakevens were 0.47% on Friday versus 1.66% for 5y5y breakevens.
ECB to react? Probably not yet but risks are rising (of euro jawboning)
Last weeks’ ECB minutes indicated that the ECB stood ready to tweak its policy as the situation (as per mid-July) “entailed the need for a close monitoring of the situation in financial markets, with a view to their implications for price stability, and a readiness to respond to an unwarranted tightening of the monetary policy stance or a change in the medium-term outlook for price stability.” And my bottom line from the above is that it now looks more likely that some of the downside risks concerning the ECB have increased.
Clearly the situation in China is fluid/subject to considerable uncertainty. As I discuss in my accompanying post my best guess is that near-term the PBOC will prevent a repeat of last week’s violent FX moves. But two of Li Kequiang’s three favourite demand indicators paint a substantially more negative picture than the suspiciously-smooth official GDP data, pointing to risks of further slowdown and CNY depreciation over a longer window or at the least an end to the era of trend CNY TWI appreciation.
Given such uncertainty, the current situation does not justify a change in the ECB’s asset purchase programme. The ECB seems unlikely to adopt a risk-management motivated further easing, not least because such a change from the “steady ahead” message could further exacerbate risk aversion. But they may want to neverthless tweak their message further, given recent developments. And an initial, less dramatic, step would be for Draghi to again start referring to the euro in an attempt to prevent its recent strength extending. Recall that last year Draghi upped the rhetoric on the euro before eventually acting.
That said, EURUSD around 1.11 is clearly different to last year’s 1.40 levels – so a return to euro jawboning remains a risk rather than my central case (even if it is a relatively “easy” thing to do). Moreover, the ECB will have been pleased to see EA inflation rise back (especially core HICP at 1.0%) given the minutes argumsnt that “There was increasing evidence that the annual inflation rate had bottomed out, even if it was considered too early to firmly declare that the range of available measures of underlying inflation showed a turning point”. But nevertheless overall the developments discussed above mean that the chances of the ECB tweaking its message at the 3 September press conference, when they will have an updated set of staff forecasts, are rising. So it may well instead be a case of tweaking the language in the press conference opening statement or the downgrading the forecasts a little. Obviously this will be contingent on EA activity and financial market developments in the interim, but the ECB minutes indicate that they are not completely tied to the current policy settings “while recent market volatility had not materially changed the assessment of the economic outlook, continued elevated uncertainty called for alertness and a readiness to respond”. At the least it’s worthwhile going through the thought experiment of considering what the ECB could do should they want to at at the margin.
Given that the debate about whether the Fed will raise rates on 17 September will likely intensify over the coming weeks – markets are currently pricing just under a 50% chance, after falling to 40% after the PBOC announcement, whereas around 80% of street economists polled by Bloomberg/WSJ think it will happen – this will likely prove to be a very interesting month, even abstracting from what the PBOC does next.