29 September 2019

The European economy has been decelerating since 2017. Indeed, the meagre 0.2% gain in GDP during Q2 2019 suggests economic activity may be stalling. And, as Germany, Italy, and the UK all recorded negative growth rates during the interval (and with Q3 looking decidedly weak as well), financial markets are increasingly concerned the region is sliding into recession. As the cartoon above indicates, the prospect of a slump is particularly worrisome, as it feels as if the last one barely ended!

What’s behind the renewed slide in European growth? How worried should we be about a recession next year? The European Central Bank (ECB) recently has provided additional monetary support. However, after years of austerity, it is now appropriate (essential) for European governments to adopt more expansive fiscal programs in order to prevent a 2020 slump. Some countries are already shifting gears, although key nations — Germany especially — are not.

It’s rarely easy to get excited about European economic prospects these days. And trust me, I am not! However, expectations are low (e.g. the OECD forecast Eurozone 2020 GDP growth of only 1%). Not only could meaningful EU fiscal stimulus help prevent a recession, but the gap between European and US GDP growth (now at 1.3%) could disappear in 2020. Such an outcome would have important implications for the US dollar, as well as the relative performance of equity and bond markets in the two regions.

Europe: Structural, Global, and Local Headwinds

There are structural, global, and special regional explanations for the recent deceleration in European activity. In part, the slowdown in Eurozone GDP — from 2.5% in 2017 to 1.25% in H1 2019 (on a year-over-year basis) — may simply reflect a return to the the region’s tepid long-term growth potential. Indeed, since the end of the Global Financial Crisis, Eurozone growth has only averaged 1.3%. To be sure, restrictive fiscal policies contributed to the previous poor performance. However, the Chart above illustrates the sharp slowdown in European productivity growth in recent decades (a pattern seen in all advanced economies). Subpar efficiency gains combined with poor demographic trends suggest that Europe’s long term growth potential is probably only 1.25-1.5%. Bogged down with Brexit negotiations, the European Commission’s failure to address immigration and investment reforms suggests underlying growth may always appear to be near stall speed.

Addtionally, global developments — in particular, the deepening US-China trade dispute — has contributed to the slower growth in the highly trade-oriented European economy. The Chart above illustrates a two-tiered economy has emerged (as has occurred in other advanced economies as well). Europe’s manufacturing sector has been suffered from slowing world-wide trade flows. Meanwhile, Europe’s service sector has remained more resilient, although less healthy than the heady days of 2017. I will discuss further the impact of the tradewar in the next section. However, as I do not expect a quick fix in the Sino-US dispute, global developments will remain a headwind.

In addition, the slump in Europe’s industrial sector has been amplified by the troubles in the world-wide automotive sector. Indeed, the Chart above illustrates that the challenges contronting the car industry are not limited to Europe. Moreever, as Germany accounts for nearly 50% of the value of European auto production, the slump has hit them hardest (although the UK and Italy have also suffered). It is worth noting that non-German EU auto production has declined less than in the USA. And, Central European output continues to advance handsomely: suggesting production relocation may explain part of the weakness in western Europe. While the global automotive industry faces important long-term challenges, the severity of the slump in Europe should ease in 2020.

The Chart above illustrates these patterns are mirrored in overall manufacturing activity. Germay fares worse, and non-Germany EU output growth is now keeping pace with the USA (although both are weak and slowing further). Central Europe is doing fine (Sweden and Norway are helped by undervalued exchange rates).

Stall Speed: Still Doesn’t Feel Like Recession Yet

Indeed, European growth is slowing, and industry has been especially hard-hit. However, despite the structural and global challenges, the tell-tale signs of recession still are not yet evident. The Chart above illustrates the while the slowdown has been broad-based during H1 2019, Germany and Italy are epecially weak (with Sweden and UK not far behind). Central Europe continues to enjoy healthy growth. And, France is finally outperforming its powerful neighbour.

I expect resilient consumer spending to provide a cushion against downside risks in 2020. To be sure, household outlays are slowing as well (Chart above). In many countries including Germany and the UK, however, the consumer is faring better than the overall economy (there are noteable exceptions, e.g. Sweden and Spain). Moreover, fundamentals for household spending are pretty good. In particular, tightening EU labour markets — combining a pick-up in wage growth and solid advances in employment — should produce respectable 2-2.5% gains in real disposable income, which should result in similar rises in spending.

Meanwhile, typically, pre-recession capital spending booms lead to over-capacity, and eventually sharp declines in business investment. None of that is evident in Europe. To be sure, global uncertainties are leading to undesireably modest EU capex expansion, and some countries (including Germany and Sweden) did experience declining investment in Q2 2019 (on a QoQ basis). However, the Chart above, fortunately, does not reveal a broad-based slump at this stage.

The prospect of a widening trade war, of course, is a major risk for the trade-oriented European economy. The Chart above illustrates that export growth has slowed in 2019, including an outright decline in Q2 2019 (on a QOQ basis). However, so far China and the USA do not appear to be behind slumping European exports. Indeed, the value of sales to these countries during Q2 2019 actually rose 6% and 14% respectively (YOY basis). Flagging intra-EU sales — up only 0.4% in Q2 — and sharply declining trade with Turkey appear more responsible for Europe’s external weakness at present. This performance emphasises the importance of stimulating EU-wide demand in the period ahead.

Brexit: A Quick Note

Of course, it would be impossible to discuss Europe’s outlook without mentioning Brexit. And, while I will deal with this topic in more detail after (if?!) it occurs, Brexit poses risks to both the UK and EU economies. For now, however, the above Chart reveals a few useful points. First of all, UK GDP has underperformed the EU-27 since the referendum. In particular, business investment and exports (the latter is very surprising following sterling’s collapse) have lagged well behind. None of this bodes well for the future. While the EU-27 may be surprisingly resilient in 2020, a UK recession appears increasingly probable. Of the many important issues, Brexit will further complicate the problems in Europe’s auto industry, as supply chains may be disrupted and the EU may impose a 10% tariff on the importation of UK vehicles.

Fiscal Space: Time to Use It!

The ECB has again showed its willingness to play its role in boosting flagging European demand, and offseting the downside risks posed by global uncertainties. Arguably, however, the usefulness of additional monetary stimulus may be approaching its limit. To be sure, the ECB has taken steps to cushion the banking sector from the extended period of negative interest rates. However, the Chart above illustrates that European banks’ net interest margins continue to decline, while those at US institutions are now recovering. Likewise, despite negative interest rates, European credit growth remains modest (3.5%), and lags the USA. As a result, the return on equity at US banks (while still lower than pre-GFC levels) is double that at European competitors (12% versus 6%). Increasingly, the ECB must balance the impact of monetary stimulus on domestic spending and the banking system.

It is now time for fiscal policy to play a larger role. To be sure, European goverment debt remains high, and limits the scope for action in certain countries (see the Chart above). However, the previous decade of austerity now has put the overall regional debt load on a downward track — with the very important exceptions of Italy and France. Indeed, in many countries, public sector liabilities as a percent of GDP are low, e.g. Germany, Netherlands, Scandinavia, and Poland amongst others.

The Chart above indicates many countries (and the Eurozone overall) have already begun to move in this direction. Indeed, populist governments in Hungary and Poland, along with Spain, have led the way. Perhaps ill-advisedly, Italy and France have followed the trend. Prime Minister Theresa May has famously announced “an end to the age of austerity”, and the UK plans higher spending post-Brexit.

On the other hand, Germany (scandalously!) continues to maintain a tight hold on the purse strings. There is scope for sizeable fiscal expansion in Germany, Switzerland, Netherlands, Austria, Scandinavia, amongst others. Indeed, with interest rates very low, EU-wide fiscal policy could be expanded by up to 2% of GDP without reversing the hard-won reduction in debt levels.

Strategic Implications

• With European core inflation remaining too low and the benefits of monetary stimulus waning (Chart above), Europe should adopt more expansive fiscal policies. If implemented, European GDP could grow over 1.5% in 2020.
• Germany should lead the way. It’s time to act more boldly!
• With the US economy slowing, Europe’s growth rate may converge with the USA for the first time in many years.
• As US growth remains stronger now, the US dollar will appreciate further. Converging growth, however, would contribute to the end of the overvalued greenback’s rally.
• Under such conditions, undervalued European equity markets should outperform the USA during the 2020 election year.