Goodbye European boom

Via Damien Boey at Credit Suisse:

Europe is slowing

Recent European data have surprised materially to the downside. For example, German industrial production and retail sales likely shrunk by around 0.9-1% in 1Q, after growing very strongly in 2017. Also, sentiment indicators have fallen sharply off historically high levels.

We are not surprised by these developments. Indeed, we expect to see more negative data surprises to come. Our proprietary European financial conditions index has historically been a reliable leading indicator of activity growth. It has been deteriorating steadily over the past few quarters to levels consistent with stagnation in the economy.

Financial conditions have tightened because:

1.    Export competitiveness has deteriorated, with the real exchange rate appreciating strongly relative to “joint parity” equilibrium.

2.    The real yield curve has flattened. Real short-term rates have risen faster than real long-term rates, consistent with less policy accommodation.

3.    Real wage growth has slowed. The basic cost of living has risen more quickly than wages in recent times.

4.    Credit spreads have started to widen.

Investment implications

We think that Europe is the swing economy in the global outlook. After all, recently sharp and negative European data surprises have led the global index lower. The past two occasions when the European data surprise index has deteriorated as sharply as it has recently were the European and global financial crises.

It is not just the quantum of euro area growth that matters. The dispersion of growth outcomes across member states also matters as well, because dispersion is a powerful leading indicator of sovereign spreads relative to bunds. Higher (lower) dispersion levels typically foreshadow wider (narrower) sovereign spreads.

We also need to consider that the state of the economy is a driver of ECB policy settings. For now, ECB officials are committed to ending quantitative easing. However, if European activity really does stagnate, we could easily see a scenario where officials back away from this course of action, supporting asset prices despite softening growth.

In a recent note (“Credit market tightening could overshadow macro-prudential loosening” dated 23 March 2018), we demonstrated that data surprise and the rate of change in global central bank balance sheets were two very powerful leading indicators of credit risk appetite. Positive (negative) data surprises and faster (slower) central bank balance sheet expansion support higher (lower) credit risk appetite and narrower (wider) credit spreads.

Against this backdrop, our concern is that data surprises are becoming negative at the same time that central banks globally have committed to shrinking their balance sheets. And even if central banks were to back away from balance sheet reduction in response to soft growth or financial market turbulence, there is some normalization of credit pricing baked into the cake over the next few quarters. In other words, the onus is on the ECB to ease off on tightening rhetoric sooner, rather than later. Otherwise, credit market conditions could tighten much more aggressively than even we expect. On the flipside, US Treasuries could benefit from safe haven flows..

The key issue for central bankers is whether or not they have convinced investors that they have passed their “Costanza” moment (for further discussion, please see our note “The Costanza moment in value investing and central banking”, dated 20 November 2017). That is, have central bankers managed to convince investors that lower rates are actually easing, having just tried to push the narrative that higher rates are supportive of stronger growth? Perhaps it is a case of going backward to try to go forward …

Quite right. The EUR has clearly overshot. The implications being that the ECB will back off and EUR/USD fall away.

Very much a part of the MB outlook for this year.

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