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Azad Zangana, European Economist, Schroders

Is Europe turning a corner?


Azad Zangana (pictured), European Economist at Schroders, looks at the bumpy ride for growth in Europe…

Investors could be forgiven for thinking that the crisis in Europe is over. There seems to be an air of calm around the current crisis that has been absent for some time. Despite no new bail-outs, or actual new money being injected by institutions, it seems that the President of the European Central Bank (ECB) Mario Draghi has convinced markets that the ECB will back-stop the system. The 10-year government bond yields in peripheral Europe are tumbling to the lows seen in February, while European bourses have outperformed the S&P500 after severe underperformance earlier in the year. Indeed, the EuroStoxx 50 index has outperformed the S&P500 by 3.4% since the start of August, while growing confidence in peripheral Europe has helped the Spanish IBEX 35 outperform the S&P500 by 12.5%, while the Italian FTSE MIB index also outperformed by 9.1%.

Since August, we see that most of the political hurdles (the election in the Netherlands and the German constitutional court ruling on that the introduction of the European Stability Mechanism (ESM) was not in violation) have either been cleared, or deemed to be relatively low risk.

Two issues remain outstanding; Greece and Spain.

A report on Greece’s progress in implementing fiscal and structural reforms is being compiled by the Troika (European Commission, European Central Bank and IMF collectively). Reports suggest all parties are close to agreeing the EUR13.5 billion worth of budget cuts, and the small number of issues around labour market reforms are close to resolution.

Greece is still waiting for its overdue EUR31.5 billion tranche from its bail-out, but without sign-off from the Troika, then Greece must continue to wait and make do. We anticipate an agreement between Greece and the Troika to follow in the near future, largely because the Greek government must be very low on funds by now. But also, now would also be bad timing for the Troika to cut Greece off, especially with Spain occupying the markets gaze – our second outstanding risk event.

Spain continues to delay the formal request for a bail-out that would trigger the ECB’s outright monetary transactions (OMT) bond buying programme. Markets are rife with rumours regarding the reason behind the delay, but it seems the delay may be serving all sides.

Germany appears to be using the delay to re-negotiate the policy on the recapitalisation of banks with bad ‘legacy’ assets, and the European-wide deposit insurance scheme which Merkel’s government now opposes. Meanwhile Spain’s Rajoy has benefited from the delay as his People’s Party fought local elections in Galicia and the Basque Country.

For Spain, falling bond yields have reduced the urgency for a bail-out, however the markets have moved in anticipation of the ECB making an intervention. We expect Spain to request a full or partial bailout or credit-line by the end of the year. This should trigger the support from the ECB, pushing yields on Spanish government bonds down further and providing support for the IBEX to make further gains. In addition, the start of ECB intervention could encourage Portugal and Ireland to make greater efforts to return to the sovereign debt market for financing – one of the conditions of the ECB buying government bonds.

Industrial production has been stronger than expected in the big four eurozone Economies which bodes well for Q3 GDP. However, leading indicators suggest further weakening in activity as we head into Q4 and 2013

Along with green shoots appearing in the political landscape, the economic outlook seems to be stabilising. Retail sales in the Eurozone are improving, while industrial production output for the big four Eurozone member states looks set to be considerably stronger than the third quarter, especially for Germany and France. In addition, Eurozone trade is increasing with a solid rise in exports to the US and the Americas, while trade to ASEAN region was flat.

We expect that the economic recovery across the Eurozone will be fragile and bumpy.  Austerity across most of Europe is hampering the recovery in final demand, making it very difficult for companies to judge the appropriate level of output. In addition, companies are aware that more austerity is on the horizon, however, the lack of information from governments about how this austerity will be implemented is causing companies to delay investment decisions, which in turn is affecting growth. Better and longer-term fiscal planning, akin to that in the UK, would help business with their planning.

Despite campaigning against austerity before he was elected, France’s Prime Minister is accelerating austerity. The French budget forecast lacks credibility. Growth is likely to disappoint, putting the fiscal targets in jeopardy.

The IMF now believes fiscal multipliers – the impact of a change in a countries fiscal position on real GDP growth – are between two and three times greater than previously estimated, lending support to those who argue that fiscal tightening should be spread out over a longer period of time.

It therefore seems strange to see France accelerate its fiscal tightening with a series of new taxes as announced in the French 2013 budget. Hollande appears to be bowing to pressure from the rest of Europe to cut the public deficit to 3% of GDP, in accordance with the Maastricht Criteria and new Fiscal Compact. The new budget assumes real GDP growth of 0.8% for France in 2013 – relatively optimistic when compared to estimates of 0.3%, and our own forecast of zero growth.

What makes the forecast seem even more optimistic is the expected tightening in the structural deficit (excluding cyclical factors) of 2% of GDP between 2012 and 2013. The government does acknowledge that there will be some negative impact on the cyclical element of public finances, as it only assumes a 1.5% of GDP improvement in the overall public deficit. The French government also expects its debt to GDP ratio to peak in 2013, and that debt servicing, will only marginally rise from 2015. In our view, both assumptions are bordering on the heroic. ECB interest rates and government bond yields are unlikely to remain close to the record lows currently seen out to 2017, especially if the governments’ growth and inflation forecasts are correct. The French government should take advice from their country men at the IMF and build in more cautious assumptions for growth, inflation and the impact on public finances.

In contrast, Italy is close to ending austerity and Mario Monti’s government believes that the recovery in growth can make up the remaining fiscal shortfall

In contrast with the change in French fiscal policy, the recent changes to the Italian 2013 budget were more positive for growth and inflation. Mario Monti’s technocrat government has decided to target a deficit of 2.6% of GDP in 2012 (compared to a previous target of 1.7%), and a target of 1.6% of GDP for 2013 (previously 0.5%). The Italian government has blamed weaker than expected GDP growth (revising down their 2012 forecast from -1.2% to -2.4%), but at the same time, opting to slow some of the fiscal tightening for next year. In particular, Monti’s government has decided to halve the rise in VAT scheduled for July 2013 to one percentage point. It also announced a modest one percentage point cut in income taxes, partly to offset the impact of the VAT hike on the poorest.

Essentially, Italy has signalled that it is close to the end of its austerity programme. Monti’s government believes that by halting tightening, a cyclical recovery can follow, which will fill the remaining gap in the public finances. As long as Italian government bond yields remain under control, then we feel that this plan is credible. However, Italy will remain vulnerable to external shocks and contagion, and so it may be forced to build extra buffers in its public finances at some stage in the future.

The politics seems to be improving in Europe. Investors continue to wait for the Spanish bail-out to take form, and an agreement between Greece and the Troika, but the improvement in market sentiment towards Europe reflects the reduction in perceived political risk. Data for the third quarter is likely to surprise on the upside after unexpected improvements in industrial production. However, leading indicators of economic activity have not turned and suggest more weakness heading into 2013.

Changes in fiscal policy present risks to our forecast. France’s decision to accelerate fiscal tightening will lead us to downgrade our forecast, while Italy’s decision to ease off fiscal tightening presents upside risks for our baseline forecast.

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