When the Eurozone moved toward the backloaded austerity paradigm, last Spring, I started to change my tune on Europe. In June, I wrote that we should watch second derivatives in the Eurozone, because the change in change numbers are a harbinger of a phase shift between recession and recovery. As with the US recovery in 2009, I have been cautious about calling this a recovery because we are still at stall speed. However, recent upbeat eurozone data signal the recovery in Europe is for real.
Eurozone economic data
As with the US in 2009, I have to caution that a technical recovery won’t feel like a recovery to most. That’s because a recovery begins just as a recession is ending, and a recession is a period of diminishing economic activity. Recovery, thus, starts from a position of diminished economic activity by definition. So the economy will be weak and the recovery won’t feel good. One has to look at the data to see whether the improvements can be sustained. I believe they can.
For example, today we saw a surprising lift in eurozone retail data. The retail sales numbers rose 1.4% month on the month in November after a 0.4% decline in October. This was the fastest monthly increase since November 2001. Moreover, on a year-over-year basis, which is more important for gauging time series sustainability, retail sales volume was up 1.6%. That was the best number since February 2008. Even laggard France showed a rise in retail sales in November. This is the best proxy for consumer demand we have. And it is showing that consumer demand is rising.
Other previous data show the Eurozone expanding as well. For example, in December the Eurozone-wide manufacturing purchasing managers index rose for the third month on the trot, with new orders rising to a two0and-a-half year high. The final PMI for December was still weak at 52.7, marginally above the break-even point for expansion of 50. However, as I indicated regarding recoveries, the numbers are always going to be weak in the beginning because one is leaving a period of diminishing economic activity. The key is the trend i.e. whether the numbers are lower or higher on a consistent basis across a wide variety of metrics.
In the US, a recovery is defined as occurring across a number of economic metrics like retail sales, GDP growth, industrial output, employment and wages. Employment is the laggard here because Eurozone unemployment is still at a record high of 12.1%, with 19.2 million people unemployed. Youth unemployment is 24.2% for a second consecutive month. When we see these numbers falling on a consistent basis. There will be no doubt that Europe is in recovery.
What are the other signs I am looking for? I am looking at anti-distress signals in particular, things like yield spreads, credit growth, and foreign investment. We should expect the core like Germany or Austria to show positive signs all around. However, the periphery is where we need to see lower spreads, higher credit growth and more foreign investment as a sign of reduced distress. And we are seeing this.
Take Spain for example. At the beginning of last year, I thought Spain would need an OMT-style safety net as it exited its Troika-sponsored bank rescue program. But, along with Ireland, Spain has escaped the Troika’s bailout program free and clear. As this week began, Spain’s 10-year bond yields were at 3 1/2 year lows, having dropped a massive 35 basis points in the prior week. As I write this, the Spanish 10-year sits at 3.80%, 126 basis points lower than one year ago. That gives Spanish 10-year bonds a spread of 191 basis points to German Bunds. Spanish 2-year bonds are hovering around a record low just above 1%.
Clearly then, in the case of Spain at least, the redenomination risk has faded away, reducing debt distress markedly. This has also caused investment in Spain to become attractive. For example, the Wall Street Journal carried an article at the start of the week suggesting Spanish bonds could continue to rally in 2014 despite their low yields. That is certainly optimistic, but it is emblematic of the positive momentum developing in Spain.
George Soros is now investing in Spain. In fact, Soros is investing in Spanish homebuilder FCC just like Bill Gates. Homebuilding was at the epicentre of the downdraft in Spain and so marquee foreign investment in that space represents a clear signal of optimism for the Spanish economy.
Spain’s GDP is now growing as are retail sales. But of most importance, Spanish home prices registered their first quarterly gain since 2010. The reality is that it is hard to stop a consumer and business deleveraging wave when asset prices collateralizing credit are falling. I see the rise in home values as the key turnaround signal in Spain, just as it has been in Ireland, the UK and the US before Spain.
Voters aren’t buying it though. 70% of the Spanish population doesn’t believe Rajoy when he says that Spain is in a recovery. That tells you that the recovery hasn’t ‘trickled down’ yet. Of course, we heard the same thing in the US in 2009 and the US is still in recovery. The question is why. Some of it is probably about it not being a real recovery i.e. it is a statistical recovery only. But it also has to do with the fact that bad debt is still increasing in Spain. Latest figures show, bad debt has now reached a new high of 13% of credit outstanding in Spain. Large companies are upbeat about recovery. I suspect the credit problem is most acute with small and medium-sized business. It isn’t clear that credit is trickling down to small and medium-sized businesses or households in Spain. There is still a degree of distress in the system that with remain for some time.
So, that’s Spain – recovering but with a long way to go.
Spain is emblematic of the cyclical progress we are seeing in the eurozone. There are near record numbers of people unemployed in Spain as the economy recovers. So we are still in a depression. And there is no external devaluation release mechanism to jump start the Spanish economy. That means we have a long road ahead of us. But the trend is clearly up.
The problem for now is the change in the price trend. Inflation is in a disinflationary trend. And while that may seem good, the problem is two-fold. First, Europe still has a debt problem and the threat of disinflation becoming deflation means those debts become more onerous. Second, interest rate policy is neutered by deflation and it will mean the ECB as an institution has to move further into the realm of unconventional monetary policy, which will be politically difficult. I do not see the ECB moving pre-emptively. Rather, I see it taking a wait and see approach that could mean it moves to late and a Japan-like trend sets in.
For now, the reduction in rates is dominating the picture, leading to a virtuous circle. The ECB has lent to banks at low rates. The banks have piled in to domestic sovereign debt. That debt has declined in yield. Bank balance sheets have been buoyed and the need for government austerity has lessened. In turn, more credit is available to business. And European businesses have been using the low interest rates to refinance and lower their interest bills. But let’s be realistic here, lending to companies is still contracting – at a record pace, in fact. The virtuous circle has only gone so far. But in time, without exogenous shocks, the recovery will gather pace in 2014.