Eurozone growth goes from setback to setback with last week’s GDP number being just the latest in a long line of similar disappointments. Soft indicators have consistently overstated the strength of this year’s recovery, and the unpleasant truth is that as one country after another has swooned under the summer heat we are down to Spain as ‘last man standing’. Our leading indicators are pointing to anaemic growth ahead for much of the eurozone and Russia’s recent food sanctions on European agriculture will only add to the downturn.
The VP Short Leading Indicator and VP Long Leading Indicator for the eurozone confirm our view of uninspiring growth for Europe. Real M1 growth and sentiment surveys appear to be stabilising, but have yet to really turn up. The weakening of the currency should help a little in the short term but we still do not see any clear evidence to expect a pick-up in growth. The yield curve, which has highlighted previous slowdowns, has continued to flatten across the major economies. This lacklustre growth outlook suggests speculation about further ECB intervention is likely to mount again towards the end of this year.
Last week’s ZEW reading from Germany was another shocker, and while we don’t place that much store on any one particular set of data, the heightened geopolitical tensions affecting German exports and outbound investment make the reading a pretty credible one.
German bund yields have dropped sharply in recent days. Bunds certainly look like a kind of win-win bet, since QE from the ECB would surely push yields down, while any lengthy postponement in QE could help reignite the euro crisis leading bunds to benefit from their safe-haven status. The only scenario we foresee that could see a rise in bund yields would be the creation of euro bonds, and the issuing of these seems to be extraordinarily unlikely at the moment.
It is impossible to understand how Italian and Spanish bond yields can be at 230 year lows unless the market is strongly pricing in Draghi QE, but this looks to be extremely unlikely before the end of the year. In the longer term Europe seems to be moving towards Japanisation but, in the short run, headline (but not core) inflation is likely to bounce back slightly from its recent 0.4% record low. Moreover, global risk factors may well keep pushing the euro lower, although the current account surplus will remain a formidable support. Both these outcomes lower the number of those on the ECB’s Governing Council who would be in favour of more easing in the short term.
Source: Bloomberg and Variant Perception
The problem is that if Draghi waits too long before pulling the QE trigger and debt continues to mount up in Italy and Portugal (where levels are already over the 130% of GDP level) the possibility of Germany demanding some sort of private sector bondholder bail-in before the beginning of QE will rise. Then, if that possibility becomes plausible, the number of bondholders willing to take the chance of holding peripheral debt will fall, thus reigniting the debt crisis.