Incorporating the 2Q GDP releases and, in some cases, revisions to past data, into our full-year estimates causes us to raise our forecasts slightly. The full-year contraction in euro area GDP this year now stands at -4%, a relatively small revision compared with the previous estimate of -4.4%. The small upgrade to the euro area estimates masks larger upgrades for Germany and France and downgrades for Italy, Belgium and the Netherlands. Our Spanish forecast stays broadly unchanged for 2009. As we left the outlook for 2H09 virtually unchanged, our 2010 full-year estimate only changes marginally from 0.5% to 0.6%. These forecast changes do not constitute a material change in view. In fact, we reiterate our long-standing call for a tepid, below-trend recovery in the euro area. We acknowledge the risk that this profile might turn out to be more bumpy than the one we currently envisage.
In our view, several headwinds will limit the revival in euro area growth in the coming quarters. We are concerned that consumer spending will experience a setback once the car-scrapping schemes run out. We estimate that car sales have boosted 2Q consumer spending by about 0.5pp and the impact in the current quarter will at best be half of that. In addition, we are concerned that a marked rise in unemployment will put a dent into income dynamics and spending propensity when the short-shift subsidies in a number of countries expire and the lay-offs pick up. We also believe that with capacity utilisation rates hitting record lows, investment in machinery and equipment will likely remain subdued for quarters to come. Last but not least, we observe that a number of euro area countries show rather substantial imbalances (notably big current account balances). While these cancel each other out at the euro area level, they might still hold back growth due to the heavy lifting of rebalancing growth inside the currency union.
That said, we are not denying that there is scope for a near-term upside surprise. This upside surprise, which is also highlighted by our own surprise gap index staying close to its all-time high in July, could come from two main sources.
First, the inventory cycle. The only really positive phenomenon in the 2Q GDP reports was another negative growth contribution from inventories of finished goods. This implies that companies stepped up the pace of destocking further in April-June. In addition, the July business surveys revealed that companies who were very bearish on their own inventory situation earlier in the year are now viewing them as nearing normal levels. This suggests that the pace of destocking could slow down in the current quarter. And such a slowdown in the pace of destocking is all it takes to get a positive growth contribution.
Second, the car sector. In the US, we expect the just-started cash for clunkers programme to add 3-4pp to annualised US GDP growth in the current quarter. Also in Europe, we see car production rebounding vigorously from the trough, thus revised a small part of the plunge the sector experienced since early 2008. For now, however, the rebound in car production does not even suffice to lift overall manufacturing production into positive territory and the bulk of the boost to consumer spending might already lie behind us. With industrial production and retail sales being down in June - thus creating a soft entry into 3Q - we believe that a small positive GDP growth rate is the most likely outcome. This view is also supported by our GDP indicators.
To sum up, incoming activity indicators still support our cautious near-term GDP forecast profile. While there might be a more vigorous bounce in the industrial sector in the coming months, this would reflect temporary factors such as the inventory cycle and a subsidy-fuelled car boom. We continue to remain wary of calls for a V-shaped recovery in the euro area. True, many graphs, notably those showing sequential growth rates, seem to depict a V-shaped pattern. It is important to remember though that all these charts are showing is a stabilisation in activity after a very steep plunge. In level terms, activity, revenues or profits still remain far below their peak of early 2008. Assuming a continued moderate recovery, it would likely take until 2013 before the euro area economy will have made back the output lost over the last five quarters, which comes to a cumulative contraction of around 5.5%.
Against this backdrop, we also leave unchanged our ECB call and expect the ECB to leave the refi rate unchanged until at least till the middle of next year. In our view, the ECB has thus reached the end of its easing cycle. The ECB will likely allow the EONIA overnight rate to gravitate below the refi rate for a while longer. But eventually it will start to bring the market rate closer to its main policy rate again by mopping up the excess liquidity in the euro area banking system. To this end, the one-year refi operations held in late September and late December could see a spread being added to the refi rate. We see this risk in particular for the December operation.
In our view, the September staff projections will likely reveal a less gloomy GDP estimate for 2010 than the current -0.3%. We are now at +0.6%. The ECB emphasised the high degree of uncertainty, the potential setbacks along a bumpy road to recovery and the lagged effects of the past contraction in activity on the labour market. Note though that for the ECB the growth outlook only matters with respect to its impact on the inflation outlook. Regarding the sequencing of its exit strategy, the ECB President clarified at the last press conference that the bank could start to hike rates before starting to unwind unconventional measures. This is in line with our note, EuroTower Insights: A Not So Easy Exit, July 8, 2009.
The UK labour market data have been sending some unexpected messages lately. This is particularly the case with the most timely indicator, claimant unemployment. Unemployment is clearly still rising, but the recent increases in the claimant count have generally been smaller than anticipated and are now a great deal smaller than only a few months ago. Indicators like company employment intentions and household unemployment expectations are still at weak levels, but are improving. That leaves (at least) two questions: What's the best explanation for these data? What does this imply for the outlook? Our current forecast, for a contraction in employment in 2010 (-0.6%) after an expected decline of 2.1% in 2009, could prove too pessimistic.
The labour market outlook has a bearing on corporate profits (lower wage settlements and layoffs as cost-cutting measures), the consumer spending outlook and the likely path of monetary policy. For the latter, wage freezes may have helped to offset some of the pressure on company profits and pricing from the weaker sterling, and the employment and unemployment outlook will have a key bearing on the MPC's assessment of spare capacity in the economy and hence medium-term inflation pressures.
Possible explanations for better-than-expected claimant unemployment
Two explanations spring to mind: 1) measurement issues; and 2) cost control and labour hoarding.
1) One explanation might be that the claimant count does not capture all the increase in unemployment, with some workers not claiming benefits and others leaving the labour force (i.e., inactivity increasing).
The lagged and smoothed survey-based indicator of unemployment should pick up those who are unemployed, but not claiming jobless benefit. However, so far there doesn't seem to be any evidence to suggest that these two measures are out of step (movements in the claimant count data tend to be a bit more extreme at turning points than the survey-based measure, and movements can be slightly out of synch). As regards inactivity, levels have increased significantly over 2009. However, the inactivity rate is only back to late 2007 levels.
2) The second explanation is that this reflects a significant degree of flexibility on the part of the UK workforce and a degree of reluctance on the part of companies to permanently cut staff. The level of real GDP is now 5.7% off its peak, but employment is only 1.9% off its peak. At a similar point in the early 1980s recession, for example (when the peak-to-trough decline in GDP was 6%), employment was 2.5% lower (and went on to decline significantly further).
We have seen evidence of significant flexibility including agreements by some employees to take unpaid leave, cut working hours and wage freezes. The output per worker measure of productivity has fallen dramatically, down 4.2%Y in 1Q09. Notably, output per hour was down ‘only' 2.4%. Some of this might reflect a fear on the part of companies that they would otherwise be unable to meet demand as the global and domestic economy pick up (most of the contacts interviewed by Bank of England agents in June and July also considered the cuts they had made to production to be temporary and easily reversible).
Companies may prefer to hang on to employees, but where they can do so without draining cash excessively. Evidence suggests that UK companies have been relatively successful at maintaining their levels of cash and working capital. National accounts data showed that, in aggregate, non-financial corporates' cash levels remain relatively high and as of 1Q09, had not yet decreased significantly. The Bank of England's July Trends in Lending publication also presented evidence that its measure of non-financial companies' financial surplus (the difference between total income and outgoings) had been broadly stable as a percentage of GDP for several years at close to 2% - in sharp contrast to the last recession where this measure had plunged into negative territory. Again, labour market flexibility should have helped this situation. Very rapid cuts to inventories will also have helped, as well as sharp decreases in interest rates.
Encouraging signals from the labour market data...
Labour market data tend to lag the cycle or at least send contemporaneous signals on activity. However, there are some indicators which appear more forward-looking. Scouring the labour market data reveals at least one measure with some claim to leading qualities for overall GDP growth: the ratio of claimant outflows to inflows. Outflows from claimant benefits have picked up very sharply, while the growth in inflows appears to have topped out.
...but some warnings too
If production capacity is being mothballed rather than cut, and if employment is being supported by low-wage settlements and flexible working, then beyond the near term any recovery in employment, GDP growth and inflation will likely not be as strong. There is less likely to be a scramble to hire in the recovery, investment spending will not bounce back as strongly and the effective capacity of the economy could expand quickly to accommodate a demand upswing.
If companies really are trying to minimize staff losses for fear of ‘missing' the rebound in activity, there may be another wave of job losses to come as the recovery likely proves challenging. Even assuming that increased demand does come through (external demand may be particularly robust with a legacy of a weaker level of sterling, putting UK producers in a relatively good position to benefit from increased global demand), the upside for employment would in that case be constrained (particularly assuming a degree of wage growth normalization).
Conclusion
While much of the UK data remain relatively downbeat (particularly more ‘backward' looking data, money supply and lending data), there are some indicators which look consistent with a sharp, near-term improvement, including from the labour market. Any such recovery could well prove ephemeral, and currently, better-than-anticipated labour market data may support the view that ultimately the recovery in the economy will be sub-par.
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