Things aren’t looking too good for Europe.
While Brexit chaos reigns here in the UK, the latest data releases point to a similarly dour outlook across the channel.
The eurozone ended 2018 on a bad note, with a drop-off in the automotive industry and widespread gilets jaunes protests in France seriously hampering economic activity.
Recent eurozone growth forecasts also dropped to fresh lows, with economists now expecting eurozone GDP to expand just 1.6 per cent this year compared with the 2 per cent expected back in March.
Along with the market, we look at purchasing managers' indexes (PMIs) as key forward looking indicators, because economic growth usually follows their lead.
In these ‘diffusion indices’, a figure above 50 is supposed to tally with economic growth, but in reality the ‘neutral’ level is a little higher, and readings around the 50 mark tend to predict stagnation.
The latest eurozone releases have been uninspiring.
The overall eurozone composite PMI fell to 50.7 this month, below consensus expectations of 51.4 and down from December’s reading of 51.1. Both manufacturing and services sectors contributed to the fall in equal measure.
The regional breakdown shows a divergence. In France, a headline composite index of 47.9 made for some dire reading, coming in well below the previous reading of 48.7. Although there was a surprising rebound for manufacturers, services saw a slide.
The reverse was true in Germany, where a decent performance by the services industry papered over a glum outlook for manufacturers, to bring the overall composite PMI to 52.1 and beating expectations.
What this shows is Europe is starting the year with even weaker growth than the lacklustre pace we saw at the end of last year.
What’s gone wrong?
The eurozone relies on external demand – doing well when global demand is strong and vice versa.
A large part of that demand is now centred around China, and another driver for demand is cars, both which have been weak recently. The world’s second largest economy suffered a slowdown at the end of last year, while the car industry’s problems across the world are myriad.
The PMI surveys seem to indicate that a deeper malaise has set in at the start of the year.
A survey from Germany’s IFO Institute on business confidence reinforced the PMI data, but added a domestically-focused slant to the gloom.
During much of 2018’s fall in sentiment towards the manufacturing sector, confidence in construction held up well. That positivity has now drained away, suggesting the external situation has finally impacted domestic drivers.
Perhaps politics has dampened economic activity and scared away investment.
Throughout 2018, Europe seemingly tried its best to provide a diversion to Brexit with its ‘showdown’ with Italy’s populist government. Then towards the end of the year, France took to the streets to protest just about everything its government was doing.
To top it off, politicians, businesses and investors now seem to be waking up to a realisation that a disorderly Brexit will hurt the EU just as much as it will the UK.
Meanwhile, long-standing structural issues have prevented domestic European demand from compensating for the global drop-off.
It’s a tired trope, but the lack of a fiscal union and strict budgetary constraints stop governments from stimulating demand through tax cuts or government investment programs. The banking system is also still relatively ineffective in recycling savings into available capital.
The European Central Bank (ECB) does its best to compensate for these problems, but its monetary tools are slow moving and rather blunt for generating demand in the near-term.
The bank’s hands are somewhat tied on quantitative easing (QE). Despite liquidity issues, the ECB is committed to removing QE and is unlikely to change course. Altogether, this means Europe lacks the capability to respond effectively to its economic problems.
But the ECB is responding in other areas. After its January meeting, it signalled that policy will be responsive. Various central banker speeches have taken on a cautious tone after a recent policy update saw a move to the downside in the assessment of risks.
The first increase to interest rates is now expected in early 2020, but holding still on rates will not be enough if the ECB wishes to end QE. The most likely proactive policy option is to repeat what are called 'targeted longer-term refinancing operations', or TLTROs, a policy deemed to be quite effective.
These are non-standard monetary policy tools which provide incentives to banks to increase their lending to businesses and consumers in the euro area.
The first series was launched in 2014 and repeated in March 2016. In the next wave, participating banks could borrow the equivalent of up to 30 per cent of their outstanding loans to businesses and consumers at a lower interest rate than usually offered by the ECB.
Banks remain willing to lend and individuals and businesses willing to borrow. But despite the warm words, demand growth is slowing and banks have become more risk-averse.
The bright spots
So where do we go from here? It might sound odd to say the eurozone has some bright spots. But bright spots it has.
For starters, it’s likely demand for cars will see a rebound this year as some of the issues that have dogged the industry fade away.
There are also reasons to be positive about Chinese demand. The government in Beijing is stimulating consumer demand and financing to small businesses.
This won’t be too supportive of Chinese equities or even short-term economic prospects, as large state-owned enterprises will get left out to dry. But a boost to Chinese consumer demand will undoubtedly help the global economy, and Europe in particular.
Fiscal policy could well be supportive for eurozone internal demand too.
Political pressure in the bloc’s two largest economies is likely to result in some moderate fiscal expansion.
President Macron has already backed down on a proposed tax hike following the protests, while Germany’s response to populism equally points to a looser fiscal policy.
This could ease some of the pressure on Italy, which is desperately trying to get fiscal stimulus past the budget hawks in Brussels.
Of course, the eurocrats aren’t usually ones to back down to demanding governments. But the upcoming European Parliament elections will make them wary of enacting harsh punishments, which could act as a rallying cry for populist parties across the continent.
As in China, Europe’s wellbeing over the next few years probably depends on encouraging domestic demand, especially in consumption.
Savings rates have long been stubbornly high on the continent, preventing consumer demand from taking off. With an effective banking system and easier access to capital, consumers can run down savings and release pent-up demand.
Thankfully, recent stockmarket turbulence is unlikely to affect credit availability too much. In the US, available capital for consumers and businesses is very sensitive to capital market moves, but in Europe’s bank-dominated lending sector this isn’t as much the case, meaning market falls shouldn’t significantly affect consumer demand.
Of course, none of these things are game changers; on their own they’re unlikely to improve Europe’s prospects much.
But taken together they point to a more positive environment, which should support the economy.
As we’ve seen, this has yet to materialise in the data. For equities, it’s likely that things won’t improve until the data itself does.
But it’s early days in 2019, and while European growth won’t be inspiring, it may well turn out better than the bleak picture we’re currently getting.