Q3 Eurozone GDP - More than Meets the Eye?

By Claus Vistesen Copenhagen

As I noted just a few days ago over at Alpha.Sources in a small review and preview this week would see the release of the Eurozone Q3 numbers and now, as it were, they are out. In general, I focused more, in my last note, on the forward looking outlook of the Eurozone economy than the actual numbers for Q3 as they were certain to show a rebound on the back of a weak Q2 reading. And as we shall see below they sure did. In essence we need to consider, as always, that quarterly national account readings are always a bit backward looking as they are released when we are deep into the next quarter. Especially in this case and this seems evident as all forecasters and analysts seem to agree that this Q3 reading is a bit of a fluke relative to its ability to tell/describe the immediate economic outlook. However, this also means that what is in the book is indeed in the book and on the back of this strong reading an aggregate growth rate of 2% in the Eurozone seems well within reach. Let us do the visual inspection first which extends the graphs I showed in the last post (linked above);


As we can see the Eurozone Q3 GDP came out, quite respectably above my forecast of 0.5%, at an impressing o.7%. This already amounts to 1.9% and although we are talking about preliminary estimates it is difficult to see how the Eurozone can go under 2.0% in 2007 although of course this is still well below those 'goldilocks' forecasts we saw in the beginning of 2007. My own forecast however of 1.7% which admittedly was also on the downside clearly seems in need for an upward revision of some degree. So far, the growth rate in 2007 has averaged 0.63% per quarter for the entire Eurozone which is not too shappy at all. Having said that, a closer inspection at y-o-y growth rates also reveal that momentum in the Eurozone seems set to level off considerably as growth remained largely stable y-o-y. Yet and even when looking at q-o-q figures, we must really also be looking forward and on the back of this very strong reading I am expecting a pretty miserable Q4 reading to say the least. However, as I have stressed many times the Eurozone is not one big economy and as such the country specific break down seems to offer some important indications as to where we are moving and why this reading needs to be taken with a pinch of salt relative to the general trend.

If we look at Germany first the headline number of 0.7% was perhaps the most surprising number for me. However and especially with respect to Germany there seems indeed to be more than meets the eye. As such and even though I would like to stress that the actual breakdown is not ready yet, the following stands out from the German statistical office destasis.de.

In a seasonally adjusted quarter-on-quarter comparison, GDP growth in the third quarter of 2007 was based on domestic factors: Capital formation in machinery and equipment and in construction was up on the second quarter. Economic growth was also supported by a moderate increase in final consumption expenditure of households and NPISHs. Contrary to the second quarter, the balance of exports and imports did not contribute to growth, which is mainly due to a marked increase in imports.

Now, let us begin with the ever recurrent trend in Germany namely the point about how final consumption expenditures contributed with a 'moderate' increase in GDP. Clearly, the actual figure is yet to be revealed but such narratives are basically 'econ-speak' for virtually flat. So, no surprise here. What was more surprising was the point about how net exports did not contribute to growth at all. Given the longstanding German track record of being dependant on exports for growth it really begs the question of where those 0.7% came from. Well, if you have studied macroeconomics 101 you will have spotted that only one thing which remains is corporate capex/investment (and of course government consumption but that is held equal). This is important because it links in with what we can expect as we move forward and specifically how we can expect corporate capital formation to wane considerably in the quarters to come. I have already noted Sebastian Dullien's analysis (see link to my review and preview post above) in which he paints a bleak picture of investment in Germany going forward. If you want to dig deeper into this Edward also has an entry up today in which he analyses the recent sharp drop in German ZEW business confidence. His analysis supports, with facts and analysis, my own prediction that corporate capex in Germany and in indeed in the entire Eurozone is heading for a sharp slowdown. So, that was Germany then.

In France, growth also rebounded strongly to 0.7% and actually if we look at the charts above we can see that the French economy has actually been accelerating in the past 4 quarters on a q-o-q basis. The break up reveals that adjustment in inventories were flat, domestic demand and investment remained the main driver of growth which confirms the traditional picture of French consumers as being more ready to spend than their Italian and German counterparts. Surprisingly and after having slashed GDP by 0.3% in Q2 exports actually contributed 0.1% after exports saw a minor boom in Q3. Now, this of course broad a slight smile to my face as my thoughts peered off to Sarkozy's numerous tête-à-têtes with ECB officials over the strong Euro. For the really data miners the INSEE release reveals that in particular intermediate goods and cars were strong export commodities. However, before Trichet picks up the phone to wheel in Sarkozy just yet I do think that also France will see a slowdown in the quarters to come. Yet, contrary to Germany where corporate investment as a key growth ingredient seems to be trending firmly down France also has a much more dynamic domestic consumption which may act as a shield.

In Spain, as can also be observed by the graph above growth continued to decline and is now in line with Germany and France at 0.7%. Clearly, this should not be seen as a sign of convergence since the 0.7% recorded by France and Germany seems to be a bit too high relative to the general trend. As such, the Eurozone has been accustomed to a Spanish economy which has grown well above the Eurozone average and in this way we can say that the Spanish economy in many ways have driven the aggregate growth rate on the margin. However, and in light of the Spanish slowdown in Q3 we also need to understand that the current market turmoil and subsequent correction which is sharply related to construction and housing is likely to hit Spain particularly hard. This, as it were is also the case of Ireland which at this point has not published numbers for q3; to the best of my knowledge that is.

Finally, before summing up we have of course Italy where Bloomberg told us that the Italian economy managed to expand in Q3. But alas what does that matter when the number we have is 0.4% q-o-q which follows, as can be observed above, a o.3% and 0.1% reading q-o-q in Q1 and Q2 respectively. Even those amongst my readers with next to none inclination towards math exercises should have no trouble calculating that the average q-o-q growth rate now stands at a measly 0.27% q-o-q. If we annualize the current figures (i.e. assume 0.4% in Q4) Italy is looking at a annualised growth rate of 1.2% (the official forecast is for 1.9% y-o-y which is well below its peers). However, do take note that these annualised figures rest on a status quo situation which quite frankly seems highly unlikely at this point. In this way, the evolution we are now seeing in Italy is not at all surprising for me and confirms the general perception that when economic fundamentals turn against the Eurozone Italy is one of the first economies to suffer. This seems to be a role Italy has the ill-earned pleasure to share with Greece and Portugal where the latter for example saw its growth rate q-o-q stall to 0.0%; Greece's q-o-q growth rate has not yet been released.

In Summary

On the face of it the Q3 GDP release from the Eurozone seems to point to a rebound but we should not be fooled. I know that I tend to be a bit of a party pooper sometimes when it comes to the Eurozone but this time around you need to consider I think that the collective mass of almost all respectable analysts and economic commentators seem to agree with my general forecast. As such, all of us Eurozone watchers had pretty much agreed that Q3 all things equal would show a rebound relative to Q2 but given the monthly real economic data and confidence readings which have been rolling in it would also prove to be short-lived. In this way I maintain my main focus on the following three things as I outlined them in my entry posted Monday this week ...

• Although the slowdown seems set to be Eurozone and indeed also EU25 wide I will be watching Italy, Greece, and Portugal in particular since these three countries are those most likely to feel the pinch longest and hardest. Clearly, I am also watching with some anxiety Germany where the recent signs that net exports and thus external demand seem to be waning suggest that growth is going to be rather meager as we move forward.

• Secondly, I am watching the EUR/USD which is still trading at very high levels at 1.46. At the moment it seems as if the much traded currency pair is taking a breather but as we move closer to the next decision at the Fed as well of course at the ECB volatility seems set to return much to the pleasure of FX punters and participants in funny money investment games :). More seriously of course, the value of the Euro at these levels and to the extent that it remains here will have consequences as we move forward.
  

• Thirdly and perhaps most importantly at this point I am watching Eastern Europe and particularly the Baltics with much anxiety. Of course, there are issues in themselves with these economies which I have treated extensively at this space. Only yesterday we learned that inflation in the Baltics continues to hasten upwards while economic growth and confidence indicators seem to be seriously wobbling. This is looking more and more like a hard landing and a subsequent/potential threat against the pegs to the Euro, especially as an extension of the fact that the EUR/USD is now at a very high level. In short, I cannot stress enough that Eastern Europe now needs ardent watching and essentially investors and most importantly policy makers need to prepare for events where prudence, responsibility, and overview must be exercised in order not to allow some of these economies to fall into what, for some countries, can only be described as an abyss.

Finally, as regards to the most general market implications of the Q3 GDP reading I still see the ECB on hold as well as I don't see the EUR/USD trading persistently over 1.47 where of course this latter claim is the equivalent of wearing a blindfold while throwing an anvil up in the air and hoping that it will not hit you on its way down.

Germany's ZEW Business Sentiment Index November 2007

Well perhaps this news is hardly surprising, but German investor confidence - as measured by the ZEW Center for European Economic Research in Mannheim - dropped to its lowest level in almost 15 years this week.




The Economic Sentiment index - which attempts to measure investor and analyst expectations - fell to minus 32.5, the lowest reading registered since February 1993. This was down from a 'mere' minus 18.1 in October. Looking at the chart, of course, it is plain that we have almost been here before, in November last year, but an unexpected upswing in the demand for German exports globally (and especially in the East of Europe) and a weaker than expected negative reaction from German consumers to the 3% VAT increase introduced in January, meant that the bleakest expectations of that moment were not realized. However now the 3% extra cost of purchasing is still with us, and the export upswing is much weaker than it was, and in addition the financial turmoil of last August is having a much stronger than expected impact on construction activity in Germany.

As a result growth in Europe's biggest economy is undoubtedly slowing, and quite fast, and, naturally, this is the conclusion that the ZEW institute itself draws. Among other factors mentioned is that the euro has risen 8 percent against the dollar in the past three months alone, and reached a record high of $1.4752 only last week, eroding on it way up the competitiveness of German exports, whilst at the same time making products from the US companies which compete with Germany in third country markets cheaper. At the same time, higher energy bills and tighter lending conditions have sapped companies' and consumers' spending power.

One other key data point which serves to back up the ZEW finding is the fact that growth in Germany's key manufacturing sector is now slowing notably. Morgan Stanley's Eric Chaney, in noting the decline which was also registered in the IFO index last month, took the opportunity to draw attention to the rather dramatic way in which German manufacturing seems to be slowing.

The devil is often in the details, as the saying goes. This might be true for the euro area economy: while the widely scrutinized headline Ifo index posted only a modest slip in October, one key detail of its manufacturing section sent a much gloomier message: production fell from a cliff in Germany, the powerhouse of the recovery so far.

More evidence for this situation was to be found in the RBS/NTC Eurozone Manufacturing PMI (Purchasing Managers' Index), which came in at 51.5 in October, in line with the preliminary “flash” reading. While the reading indicates (as does any over 50) that output is still expanding, the fall from 53.2 in September was the largest decline to be registered in almost three years and the reading showed the weakest monthly expansion since August 2005. This weakening in the PMI was led by Germany, where the index showed the largest points fall in the eleven-year history of the survey. The PMIs also fell in Spain and Italy, while the reading was unchanged on a month earlier in France.

This easing-up in the rate of growth is the steepest recorded since November 2004, largely reflecting the sharpest slowdown in production growth seen in Germany for five years. Although Germany still continued to record the fastest growth of output in the eurozone big-four, the rate of increase was the weakest for over two years. Output growth also slowed to the weakest for at least two years in all the other big-four countries, slowing to near stagnation in both France and Spain, with France recording the weakest rate of expansion of the big-four.

Output rose for investment, intermediate and consumer goods, with the former continuing to show the strongest rate of increase. However, investment goods production slowed to the weakest since November 2005, reflecting a particularly sharp easing in Germany.

Growth of new orders was only very modest and was the lowest for two-and-a-half years. New orders in fact fell in Germany for the first time since August 2005, dropping at the fastest rate since November 2004. A marginal decline was also recorded in Spain (the first drop since June 2005). New orders rose in both Italy and France, but in both cases the increases were only very modest.

New export orders rose only modestly, showing the weakest increase during the current 29-month period of expansion. Sharply slower growth in Germany and Italy brought their export growth into line with the modest pace seen in France. Meanwhile, new export orders fell (though only very marginally) for the second month running in Spain.

Backlogs of work fell for the first time since June 2005, dropping in Germany, Spain and Italy. Stocks of finished goods meanwhile rose slightly for the first time since March 2005, caused by sluggish sales. Rising stocks and falling backlogs, of course, point to weak future production, and this is really the overall meassage which we are getting from the data at this point.

German Industrial Output September 2007

German industrial output continued increased in September, although the pace of increase is definitely slowing.

Production rose a seasonally adjusted 0.3 percent from August, when it advanced 1.9 percent, according to data released by the Economy and Technology Ministry in Berlin yesterday. From a year earlier, output rose 6 percent when adjusted for the number of working days.

Growth in emerging markets such as Russia and Eastern Europe is helping offset the impact of the euro's appreciation on exports, encouraging companies to expand. Still, record oil prices may curb economic growth as they erode spending power among Germany's customers, and stagnant internal demand may also take a toll. In one indication of this new factory orders dropped 2.5 percent in September from August, according to the Economy Ministry in an earlier release.