Eurozone chock full of slack

Via Westpac’s today Elliot Clarke:

The second estimate for Euro Area GDP confirmed a 0.6% gain for the September quarter. Following March’s 0.6% and June’s 0.7%, that leaves annual growth materially above-trend at 2.5%yr.

However, what got the market’s attention was not this headline result, but rather the acceleration in growth in Germany. There, annual growth rose from 2.3%yr to 2.8%yr, continuing an uptrend in train since the cycle-low of 1.3%yr at end-2015.

France and Italy have also gained considerable momentum, from 1.2%yr and 1.0%yr respectively at end-2016 to 2.2%yr and 1.8%yr at September. Meanwhile, Spain has remained the strongest major nation in the region, averaging annual growth of 3.1%yr over the past year.

These strong outcomes create two points of tension: (1) to what degree is this growth trend sustainable; and (2) for policy makers, is it possible that the economy could ‘overheat’, requiring an abrupt shift in policy.

On the first point, not too long ago we highlighted how significant household debt had been for consumption, allowing it to grow much more strongly than incomes. Between February 2015 and August 2017, household debt rose by a cumulative 2.7% of annual GDP, a 1.1% of GDP addition of debt per annum (around 0.3ppts of which was consumer credit). However, these are aggregate figures for the region. Country by country, the story is nuanced.

Starting on a positive note, consumers’ contribution to the strong growth seen in Spain and Germany looks to have principally been driven by income growth and savings. This is most evident in the sharp decline in the unemployment rate for both countries.

The credit data for each nation is also supportive of this view, at most showing credit growth proportionate to their income and wealth. Though household credit growth has been accelerating for a number of years in Germany, it has done so at a steady pace and only after the unemployment rate fell to historic lows. For Spain, the annual rate of household credit growth remains negative; so, at least in net terms, the growth being experienced by that economy is being funded by income/ savings (not debt).

France on the other hand is in a difficult situation. With the unemployment rate holding near record highs, credit growth has clearly been a key support for consumer spending. As a side note, this is also true of business investment. The experience of Italy over the past year gives some guidance on the likely path forward for France. Credit growth in Italy, having accelerated for a time, subsequently ebbed from late-2015 and has since been soft.

The point to draw from this analysis is not that we expect total growth in the region to fall abruptly, but rather that the positive income story obvious in countries like Germany and Spain is yet to broaden sufficiently such that Euro Area growth in excess of 2.0%yr is sustainable year in, year out. For this to occur, a much larger improvement in the region’s labour market is necessary, one that not only creates income through increased head count, but also via real wages growth on an hourly basis. The ECB has made clear that this is not (yet) the case, suggesting at their September meeting that real wages growth is instead broadly flat.

For policy makers, there is clearly a need to continue their extraordinary support for the economy: asset purchases to the end of 2018; and an on-hold refinance rate through 2019. Outside of perhaps Germany, concerns over inflation and financial stability are unlikely to come to mind amongst authorities unless labour market slack is materially reduced from here and/or we see a broad, outsized gain for credit in excess of real income growth. Neither of these conditions currently exist, and we do not believe they are likely in the foreseeable future.

Completely agree. EUR to remain weak and by extension DXY strong.

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