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The downward revision in our forecasts largely stems from disappointing dynamics in domestic demand. While we never harboured high hopes for euro area domestic demand, we now pencil in a further small contraction in 2010. At the same time, a weaker euro caused us to raise our estimates for the growth contribution coming from net export demand by two-tenths of a percent.

There is no mistaking the weak domestic demand across the euro area. While overall euro area consumer spending fell slightly in 4Q, investment spending contracted markedly again after a temporary bounce in 3Q. We expect this weakness in domestic demand to continue in 1H10 on the back of deteriorating labour market conditions, low capacity utilisation rates and relatively tight credit conditions. Only in the second half of the year do we expect this weakness to give way to a modest recovery. 

Notably, consumer spending will likely move deeper into negative territory in early 2010, we think, as the payback from the French car-scrapping scheme expires in January. We also expect an ongoing retrenchment in construction activity in 2010, especially in the first few months of the year when the unusually cold winter weather temporarily added to the downward pressure. Investment in machinery and equipment is likely to stabilise as corporate profits, business sentiment and capacity utilisation rates recover. We might even see some small gains, reflecting repair and replacement needs. 

After putting in quite a spurt in the second half of last year, exports of goods and services should continue to show decent growth rates, but at a more moderate pace. It is still too early to expect the weaker euro to boost export performance in early 2010. By contrast, the slowdown in global growth and hence trade volumes is likely to dominate in the near term. As we had feared, the transition from an export-induced turnaround in the industrial inventory cycle toward a sustained recovery in domestic demand remains bumpy, the rate of expansion below par, and the domestic demand recovery brittle.

‘BBB recovery' is not just choppy in terms of headline GDP. It is also uneven among different countries. In 4Q09, France was the only country among the larger euro area countries that expanded at all. Over the same period, the German economy stagnated and both the Italian and the Spanish economies contracted mildly. In France, it was mainly consumers pulling forward car purchases ahead of the expiry of the car-scrapping scheme that boosted consumption and hence overall GDP growth. In Germany, by contrast, consumer spending fell sharply again between October and December, having already retrenched markedly between June and September. Investment spending also fell back into negative territory. Only net export demand saved the day, lifting overall GDP by 2.2pp - thanks also to an outright contraction in import demand. For more details on our country forecasts, please see Global Forecast Snapshots, March 10, 2010. 

The uneven nature reflects different factors, we think. First, the timing of withdrawal of policy stimulus (notably the car-scrapping schemes) and its impact on consumer spending. Second, the size of the housing market correction and its repercussion on construction activity. Third, net foreign demand and its contribution to overall GDP growth. As usual, net export demand partially reflects domestic demand dynamics, which is a key driver of import demand. But it partially also reflects the export performance per se. Currently, we observe a stronger revival in demand from outside Europe, which is benefitting countries that send a larger share of their exports overseas (e.g., Germany and also Italy). Fourth and finally, the inventory cycle seems to be at different stages in different countries. Further aggressive destocking weighed on 4Q GDP in Germany, while less aggressive destocking boosted GDP considerably in France. While we are always wary of reading too much into the inventory dynamics because it is essentially a residual between the production dynamics and the demand components in the national accounts, we observed a shift in companies' inventory management in this cycle.

In our view, something unusual is going on in industry in the euro area, notably the inventory cycle. We first highlighted a new pattern emerging in the inventory cycle a year ago (see Inside the Inventory Cycle, February 23, 2009). It seems that manufacturers embarked on a very aggressive cutback in inventories in the course of the downturn. These cutbacks reinforced the recession and, in our opinion, were a key reason for the unprecedented decline in activity globally. The aggressive destocking caused companies' inventories to turn around much earlier and more quickly than their order books - a clear deviation from the close co-movements between both series observed historically. Contrary to our initial expectation, the gap between orders and inventories (which has widened to more than two standard deviations) has not closed yet. If anything, those hoping that the gap would close by order books catching up with inventories were disappointed. Instead, companies are now reassessing the inventory situation and have reported no further gains in current production. The slippage in the survey data is even more surprising, given the strong growth momentum in industrial activity abroad and the recent weakening of the euro's external value. 

It might be that we are observing a regime shift in inventory management in the manufacturing industry. Two factors could have caused such a regime shift: First, the widespread use of just-in-time management and globally integrated production chains made this the first fully technology-enabled global recession. It seems that companies have reacted much faster to a shortfall in demand in this last downturn than they have ever done before, causing inventory levels to be very low by historical comparison. Second, credit availability became a concern for many companies as soon as the financial crisis set in. Against this backdrop, worries about the ability to fund an inventory overhang have likely reinforced the destocking process. As a result, the inventory cycle acted as an accelerator during the downturn (rather than a buffer between production and demand). Therefore, we will be watching the inventory cycle very closely in the coming months to assess whether it also could act as an accelerator in the upturn.

Our surprise gap index declined sharply and could soon become negative for the first time since February 2009. If the index, which measures to what extent companies are surprised by recent production trends compared to their own expectations three months ago, fell deep enough into negative territory to break through the lower bound of the neutral range, our business cycle compass model would start to signal the risk of a renewed downturn. In this case, a double-dip could no longer be excluded in the euro area. For now, however, our proprietary indicators point to an ongoing recovery with rather meagre GDP growth rates. Our GDP indicator - both the top-down version based on euro area data and the bottom-up version based on country dynamics - points to 0.2%Q GDP growth in 1Q and puts the first sighting shot for 2Q in the range of 0.3-0.5%Q. If the surprise gap index started to surge again, this could be an indication that some upside surprises in growth could be in the making in the spring. 

It is important to note that the weakness observed in the manufacturing sector is manifesting itself before any fiscal austerity measures in the euro area periphery have even been implemented. Contrary to some of our colleagues and clients, who are concerned that these fiscal austerity measures could drag down euro area growth, we don't think that the fiscal policy tightening in the periphery is sizeable enough to have a meaningful impact on overall Euroland growth for two reasons. First, the small size of these countries (Greece, Ireland, Portugal and Spain together account for 17% of the euro area). Second, the expansionary fiscal policy stance pursued in the core countries. What worries us more at this stage is the weakness in the core countries. EMU-wide fiscal consolidation is a story for next year.

The ECB prepares a gradual exit from the extra-expansionary policy stance. Against the backdrop of a gradual sub-par recovery and muted inflationary pressures, there is no rush for the ECB to raise interest rates, we think. When the weaker euro and the elevated commodity prices feed through into higher consumer prices next year, we expect to see headline inflation back at the ECB's price stability norm based on our upwardly revised inflation forecast, which now stands at 1.8% compared to 1.5% before. Given its preference for gradual and predictable moves, the ECB is fully aware that it will take quite a while to get from the present extra-expansionary policy stance towards a neutral range of interest rates between 2.75% and 3.25%.

As a result, the ECB will likely move as soon as it deems the recovery in domestic demand is secure and the bank lending cycle has turned around. While we still expect the ECB to raise rates before year-end, we have pushed the timing of the first rate hike back by one quarter and now look for a first rate hike in 4Q10. Note that the absence of inflationary pressures over the forecast horizon is no reason not to raise rates. Indeed, if there were some inflation concerns over the policy relevant horizon of 12-18 months, this would require a monetary policy stance that is outright restrictive rather than one that is a little less expansionary than before (see Eurotower Insights: Taylor-ing Rates for the Exit, July 29, 2009).

Ahead of any hike in the refi rate, the ECB will gradually withdraw term-funding.  As previously announced, the ECB confirmed at the March Governing Council meeting that it will phase out both the one-year and the six-month tenders. While the last one-year tender was held in mid-December, the final six-month tender will take place at the end of this month. Like the December one-year tender, the last six-month tender will be offered at a tracker rate, which, from an interest rate perspective, should make banks indifferent between bidding for term funding and rolling over weekly MROs. 

In addition, the ECB announced that its three-month LTROs will revert back to competitive auctions as soon as the late April tender. While this implies that all bids for three-month funding will no longer be filled automatically, the ECB has made it clear that it will manage the liquidity in the LTROs with a view to "ensuring smooth conditions in money markets and avoiding any significant changes between bid rates and the prevailing MRO rates". Contrary to earlier LTRO auctions, held until October 2008, the ECB is introducing a minimum bid rate to the LTRO. Hence, LTRO cannot fall below 1%. Historically it has sometimes dipped below the refi rate when the ECB was in easing mode. The average spread of long-term refi rate over the refi rate since the start of EMU has been about 15bp; in tightening cycles, however, it tended to be higher, averaging about 30bp.

For now it still offers unlimited funding at weekly and monthly maturities. Finally, the ECB committed to leave its weekly MROs and its monthly Special Terms Refi Operations (STRO) at fixed rates with full allotment at least until the maintenance period ending on October 12. At this stage, the ECB has no intention of managing the EONIA overnight rate closer to the refi rate. If EONIA creeps higher over this timeframe - for instance, when the jumbo one-year tender rolls off at the end of June or when the last six-month tender expires at the end of September - this would entirely reflect the lower bids submitted by the banking system. Managing the EONIA overnight rate higher starting in October by ending full allotment would be consistent with a first refi rate hike in December. 

To sum up, the gradual withdrawal of liquidity by the ECB will cause the average maturity of the funding available to the banking system to decline. As a result, we would expect the MROs to regain in importance, even though we expect both the STRO and the three-month LTRO to be well bid too. As the ECB stops offering longer-dated funding, the respective EURIBOR rates have moved back above the refi rate, pushing up funding costs for banks and indirectly costs of capital. At the same time, the ECB leaves the safety net that is the full allotment process in place for weekly MROs and monthly STROs. In the autumn, the ECB will need to decide whether it can afford to remove this safety net, which guarantees unlimited liquidity to eligible counterparties, or whether it needs to actively intermediate the interbank markets (see EuroTower Insights: Executing the Exit, November 11, 2009).

Expect ten-year Bund yield to rise above 4% this year, a marked rise from the current level of 3.12%. While we shaved a few basis points off our year-end target for ten-year bond yields to reflect the changes to our growth outlook and our ECB call, we still see several factors pushing bond yields higher this year. First, the market is not priced for an ECB rate hike before year-end. Second, thus far fiscal austerity is not meaningful for the euro area as a whole. And it remains to be seen whether Germany, France and Italy really embark on a belt-tightening exercise next year. Third, the full extent of the sovereign crisis in the wake of the financial crisis spreads from periphery to the core. Potential solvency issues at the periphery could cause dilution of credit quality at the core (see Greece and Euro: Between a Rock and a Hard Place, February 22, 2010). Within the euro area the sovereign risk is mainly a credit risk, given that the ECB is not allowed to fund governments directly. Globally, however, it will likely morph into an inflation risk, given that the US and the UK governments have the possibility to fund budget deficits at the central bank directly and also have the incentives and the means to lean on their central banks to tolerate inflation overshoots in an attempt to deflate the debt burden (see Global Monetary Analyst: Debating Debtflation, March 3, 2010). Bond markets, where many market participants are still fretting about deflation, are not priced for rising inflation pressures in some of the world's largest economies. Fourth, the global environment will become less bond-market friendly once some of the concerns that have spooked equity investors (notably the rollover of the leading indicators and the start of monetary policy tightening) blow over.

There is one important wildcard to our bond yield call: the unwinding of the ECB's unconventional policy stimulus measures. Once the ECB starts to get back in the driving seat as far as liquidity is concerned - by moving away from full allotment in the MROs and the STROs - there could be potential repercussions on the indirect quantitative easing (QE) via the banking system that has characterised the ECB strategy in expanding its balance sheet in reaction to the crisis. By offering generous liquidity to the banking system - in terms of the interest rate, the size of the funds available and the collateral against which it lends - the ECB induced euro banks to load up on government bonds (about €350 billion were bought since the start of the crisis). Here, any liquidity withdrawal together with any regulatory changes looming over the coming years - notably about liquid asset buffers - as well as risk-management considerations could affect the way in which banks will manage their balance sheets.    

Global
What Fiscal Tightening?
March 12, 2010

By Joachim Fels, Manoj Pradhan & Spyros Andreopoulos | London

Don't worry about 2010 growth: We continue to forecast solid, above-consensus global GDP growth of 4.4% this year - despite growth downgrades in Europe, a weaker 1Q in the US (largely weather-related) and the recent softening in the China Manufacturing PMI (reflecting Chinese New Year seasonality, in our view).  Monetary and fiscal policies remain very expansionary around the globe, asset markets - though wobbly in January and February - continue to be supportive, and the rebalancing towards domestic demand-led growth in EM economies is in full swing.  Thus, we believe that the risks of a global double-dip this year are low.  Rather, we think that economic growth could surprise on the upside over the next couple of quarters - note that our US team's preliminary forecast for March payrolls is for a whopping 300,000 gain!  We don't think that bond markets are prepared for positive growth surprises and we thus continue to look for rising yields.

But downside risks for 2011: At the same time, we think that downside risks for the global economy in 2011 are mounting, for three reasons.  First, many central banks in EM are about to start tightening monetary policy, and we expect the Fed to nudge official rates higher from 3Q10 and thus earlier than markets currently expect.  Monetary policy works with a lag, so most of this will only impact 2011 growth.  Second, our macro team is looking for significantly higher bond yields this year and for a sell-off in developed equity markets.  If so, it would dampen growth prospects for next year further.  Third, we expect sovereign debt concerns to spread throughout the advanced economies as fiscal policy in most developed countries is on an unsustainable path.  If (a big if, as we discuss below) governments tighten fiscal policy significantly starting next year (this year, most countries are still easing fiscal policy), this would hurt growth.  But if they don't tighten, bond yields would likely rise even more and consumers would likely become even more cautious, again hurting growth. Taken together, we currently look for a moderate slowing of global GDP growth to 4% next year.  However, we think that the risks to next year's growth outlook are skewed heavily to the downside.

Upgrades/downgrades support our global themes: The upgrades and downgrades to our regional GDP forecasts over the last three months serve to underline the first three of the five global economic themes which we laid out in more detail three months ago (see the previous Global Forecast Snapshots: 2010 Outlook: From Exit to Exit, December 9, 2009).

1.         A tale of two worlds: EM over DM: Upgrades to our Asian GDP forecasts in February (see Global Economics: Asian Amplification, February 4, 2010) and a recent revision to Mexico have pushed up our global EM GDP growth estimate to 7%, from 6.5% last December.  Meanwhile, we look for relatively meagre 2.2% GDP growth in the G10 this year, up a quarter point since December.

2.         BBB recovery in G10: The data flow over the past three months underscores the bumpy, below-par and brittle nature of the recovery in the advanced economies.  For bumpy, see the swing in US quarterly GDP growth from 2.2% in 3Q09 to 5.9% in 4Q09, back down to an estimated 2% in 1Q10 and back up to a forecasted 4% in 2Q10. For below-par and brittle, see the disappointing 4Q09 outcome and the weak start into 2010 in the euro area and the UK. 

3.         G3 growth differentiation: Moreover, the gap between our US growth forecast for 2010 (3.2%, up from 2.8% in December) and our euro area forecast (0.9%, down from 1.2%) has widened over the past three months. With our Japan team having bumped up its 2010 forecast by 1.4 points to 1.8% last month, Europe now looks likely to be the weakest link within the G3.

What fiscal tightening? Another of our five themes for 2010 - an emerging sovereign debt crisis in the advanced economies - has come to the fore with a vengeance over the past three months due to the fiscal issues surrounding Greece and other peripheral European countries.  Many investors have concluded that high budget deficits in many countries will force governments to implement big spending cuts and/or tax increases over the next year or so.  However, our economics team disagrees. We expect 2011 budget deficits in the major advanced economies to decline only marginally from their (in many cases multi-decade) highs in 2009/10:

•           In the US, despite relatively solid economic growth, our team anticipates only a measly decline in the budget deficit from 11% of GDP in 2009 to 8.6% by 2011.

•           In the euro area, this year's budget deficit should rise to 7.1% (from 5.6% in 2009) despite tightening efforts in peripheral countries, mainly due to fiscal expansion in Germany, and decline only marginally to 6.3% next year.

•           In the UK, we currently pencil in a deficit reduction from 12.4% last year to 10% in 2011, though much depends on the outcome of the upcoming general election.

•           In Japan, we even look for a further rise in the budget gap from 7.4% of GDP last year to 9.4% by 2011.

Thus, our current judgement is that fiscal deficits will remain high as far as the eye can see in the major advanced economies.  In part, this is due to political complications.  In the US, gridlock looms after the mid-term elections in November; in Germany, Chancellor Merkel's junior coalition partner is pressing for further tax cuts; in France, presidential elections will be held in 2012; and in Japan, the government is weak. But economics also plays a role: the ‘BBB Recovery' will make governments reluctant to implement major fiscal tightening, in our view. Hence, public sector debt levels are slated to rise further over the next couple of years. By 2011, we see general government gross debt as a percentage of GDP exceeding 90% in both the US and the euro area, approaching 90% in the UK, and exceeding 200% in Japan.

Implications of rising debt: The ongoing fiscal malaise has three main implications. First, while fiscal, combined with monetary, stimulus has been instrumental in avoiding another Great Depression and stabilising the financial sector, high structural deficits and rising public debt will weigh down on the growth potential in coming years.  Consumers are likely to become more ‘Ricardian', trying to offset public dis-saving by saving more in anticipation of higher future taxes and lower future transfers.

Second, fiscal concerns and the flood of government bond issuance are likely to induce investors to demand a risk premium in government bond yields across the developed world, thus contributing to a significant increase in bond yields this year.  This, in turn, will contribute to slower growth in 2011, as discussed above.

Third, as we discussed in more detail in our various recent pieces on ‘Debtflation' (see The Global Monetary Analyst, February 10, 2010, and The Global Monetary Analyst, March 3, 2010), rising public debt levels increase the incentive for governments and central banks to inflate away some of the debt, especially as only some of the debt rolls every year and as investors have usually been slow to take on board shifts in the inflation regime.  Thus, rising debt raises the spectre of inflation - another reason to look for higher bond yields this year.

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