EM-DM divergence accentuated: As we see it, the combination of a ‘BBB' (bumpy, below-par, brittle) recovery in the advanced countries and continued (relative) strength in many emerging market economies accentuates the monetary policy divergence between advanced and emerging economies. In the former, the Fed, the Bank of England and the ECB look set to keep the various stimulus measures in place for even longer and Japan even seems to be edging closer to additional monetary stimulus, as our economics team there has long been expecting. This will likely sustain the ‘AAA' (ample, abundant, augmenting) global liquidity regime, which is policy makers' response to the BBB recovery. But in turn, AAA liquidity generated in the advanced economies and spilling over into EM economies through lower global bond yields and capital inflows will allow EM central banks to withdraw some domestic monetary support without risking a sharp deceleration of their economies. Note that we expect the central banks of Brazil, Indonesia and Malaysia to hike official rates next week, followed by Korea, India, Taiwan and Peru in the further course of September.
US-Europe asymmetries: Economic growth in the US and the euro area has been the focus of intense attention, and rightly so. Interestingly, though, while markets have been willing to take the sharp slowdown in US 2Q GDP at face value and seem eager to extrapolate it into 2H, strength in 2Q euro area and the UK GDP (around 4% saar in both cases) has been largely dismissed as temporary and due to special factors, giving way to much weaker growth in 2H. Our European team agrees that growth will fall back to a sub-par pace in the current and next quarter; however, risks to this view seem to be on the upside following the strong July and August German Ifo business surveys. Perhaps more importantly, our US team is looking for a moderate rebound in US growth to around 3% in 2H10, which would pour cold water on the widespread double-dip view. Reasons for the expected rebound include relatively solid consumer spending growth, supported by decent personal income gains, a continued capex recovery, the beginning of an inventory accumulation cycle (rather than an end to a cycle) and some unwinding of the outsized surge in imports during 2Q which led to a huge negative swing in net exports. However, it may take a while longer before these trends become apparent.
Global liquidity will likely remain abundant: Weak data from the US and Japan, along with the deflationary concerns, have already pushed global bond yields lower. Additional pressure on US Treasury yields has come from the related recent FOMC decision to reinvest the proceeds from maturing MBS securities into US Treasuries across the yield curve. Also, the Fed continues to retain the option of further enhancing its QE programme should economic conditions dictate such an enlargement. This policy option is likely to cap any rise in bond yields while double-dip and deflationary concerns persist. The combination of ultra-low US policy rates and bond yields will likely continue to push excess liquidity into the global economy and markets for a considerable period of time, especially as other major central bank are also likely to keep policy supportive for longer (the ECB and BoE) or even implement additional easing measures (the BoJ).
Emerging markets should also benefit from these policies: The AAA liquidity regime in the advanced economies provides policy support to advanced and emerging economies alike. EM central bankers are therefore able to withdraw some monetary policy support using domestic policy rates, knowing that global liquidity will remain abundant. With ample liquidity globally, domestic tightening in EM economies will not have as strong an effect as would otherwise have been the case. It is interesting to note that the willingness of EM central banks to raise rates even as markets debate a double-dip also displays a fair bit of confidence in the global recovery.
A more balanced EM economy: Most AXJ economies printed slightly lower 2Q GDP (year-on-year) prints while CEEMEA and LatAm economies (with the notable exception of Turkey and Brazil, respectively) produced better results in 2Q. These year-on-year numbers are clearly subject to many statistical issues such as base effects, and should be interpreted carefully. However, additional feedback from our regional EM teams and looking at estimates of sequential growth does not alter the picture much.
AXJ economies did witness a slowdown, but a relative modest and salutary one: In China, for example, sequential growth is estimated to have slowed down from 2.2%Q (non-annualised) in 1Q to 2.0%Q in 2Q (see Goldilocks on Track Despite Faster Moderation in Growth, July 15, 2010). This is hardly the kind of slowdown that should send warning signals about a dramatic retrenchment of economic activity. In fact, sequential growth in the AXJ region remains strong and should prompt policymakers to keep taking rates higher in many countries. Given how low rates fell during the Great Recession, raising rates in a measured fashion should still allow enough by way of a monetary stimulus to persist.
The RBI continues to deal with an inflation problem, and Bank Indonesia is also expected by our colleagues to start raising rates in response to higher inflation in its own backyard. Elsewhere in the AXJ region, policy tightening will likely continue, albeit at a measured pace. In China, in particular, our colleagues expect the renminbi to appreciate against the US dollar, but monetary policy will likely compensate by keeping policy rates low for longer and by easing the restrictions on credit extension. Overall, the AXJ region as a whole appears to be headed for a soft landing, with monetary policymakers coaxing economies towards a more sustainable growth path.
CEEMEA and LatAm recoveries also holding up well: The CEEMEA and LatAm regions played catch-up with the AXJ region in 2Q, a trend that leads to a less unbalanced EM economic structure. However, one should be careful not to extrapolate trends from such a short time span. Feedback from our regional teams suggests that the 2Q performance in the LatAm region may not be as strong as some of the quarterly numbers suggest. Growth there probably started 2Q strongly but finished it on a much weaker note. The risk is that the weaker growth story continues going forward, which would keep LatAm from catching up with the AXJ region, and also slow down monetary policy tightening. In CEEMEA, the growth story seems to be more uniform. Even in Turkey, where the huge 11.7% print in 1Q was always likely to dominate any 2Q number, the story behind the year-on-year numbers is important. According to Tevfik Aksoy, base effects from a weak 1Q09 GDP print explain part of the large 1Q10 YoY GDP number and growth in 2Q is therefore not as weak as a simple comparison, as an expected 6% print for 2Q GDP would suggest. In 2H10, Turkey is still likely to see positive but noticeably slower growth, for which the early signs of moderation have already emerged so far in 3Q. The lagged impact of weak growth in Europe and the weakness in the euro is also likely to take its toll on growth. Meanwhile, in Central Europe, Pasquale Diana notes that while the year-on-year numbers showed continued improvement, sequential data show a more mixed picture, with Hungary for example slowing in sequential terms. Across Central Europe, growth in the first half of the year was mostly net export and inventory-driven, so he thinks that some slowdown in quarter-on-quarter growth rates looks reasonable in 2H as foreign order growth slows, industry takes a breather and inventory levels are closer to normal. Credit dynamics look still rather weak, job creation is slow and policy is tightening in some countries (the Czech Republic, Romania), so domestic demand is unlikely to be a significant growth driver, in Pasquale's view.
Divergence in growth and policy paths: The divergence in the growth paths between DM and EM economies should continue to increasingly show up as a divergence in their policy paths as well. While the slowdown in DM economies provided markets with a timely reminder of the tepid nature of the BBB recovery there, slower growth in EM economies is more salutary and should allow monetary policymakers to continue to raise rates further (or, in the case of China, to allow appreciation of the currency against the dollar). The abundant liquidity provided by central banks of the major economies will likely allow EM central banks some legroom and prevent their domestic tightening from having an unnecessarily strong impact on domestic growth. Against this backdrop, our team expects the central banks of Brazil, Indonesia and Malaysia to hike official rates next week, followed by Korea, India, Taiwan and Peru in the further course of September.
A Very Strong 2Q GDP Indeed
The detailed report on 2Q GDP confirmed that the German economy indeed expanded by a sizeable non-annualised 2.2%Q between April and June of this year. Using the US methodology of annualising the quarterly growth rates yields a noteworthy 9% rate of expansion. The strong performance causes Germany to stand out among the industrialised countries. The euro area grew by a more moderate (annualised) 3.9%Q, Japan by a disappointing 0.4%Q, and the US by what likely will be a downwardly revised 1.3%, according to our US economists. In fact, Germany even outpaced China in 2Q, which expanded by 8.3%Q SAAR, according to our Greater China team. In this note, we analyse the factors behind the unusual strength, present our new upwardly revised forecasts, and discuss whether Germany is becoming a locomotive for the euro area.
Raising Our German Forecasts Once Again
On the back of the unexpectedly strong 2Q and upward revisions to past data, we are revising headline GDP growth to 3.4%, up from 2.5% before. This is the second upward revision this month, and it brings the total upward revision to 1.5pp compared to late July. If our new forecast turns out to be more or less correct, 2010 will mark one of the strongest years since reunification - on par with the boom years of 2000 and 2006 when the economy expanded by 3.2%. Next year, we expect another above-trend growth rate of 1.7% for Germany - a marked slowdown from this year's performance.
Highlighting Upside Risks for the Euro Area
At this stage, we are not making any changes to our Euroland estimates because the 2Q GDP flash estimate came in as expected. As a result, our forecasts stay at 1.5% and 1.3% (see Euroland Economics - Chewing on Green Shoots, August 5, 2010). But the upgrade to our German forecast introduces some upside risks to these numbers. First, we see some scope for the Euroland 2Q GDP estimate to be revised higher from its flash estimate of 1.0%Q, although we reserve our judgement until the detailed data are at hand. Second, we see scope for some positive spillover effects into the rest of the euro area going forward. As a result, our Euroland estimates now clearly have some cushion built in against potential downside surprises.
Mind the Catch-Up Post the Plunge
In light of the remarkable growth performance, it is important to maintain some perspective and remember that the German economy is still playing catch-up after the very deep recession of 2008/09. During the financial market crisis, activity plunged by a cumulative 6.6% from the latest peak in early 2008. Up to and including 2Q10, the German economy has made back only about 60% of these output losses. Before the level of overall activity gets back to where it was in early 2008, the economy still has a further 2.7% to go. On our forecast, it will probably take another six quarters or so to close this gap. It might not become a lost decade but it certainly was a lost few years.
Structural Factors Behind the Strong Performance
A number of structural factors lie behind the strong performance in Germany:
• One of the key factors, in our view, is that Germany Inc. embraced globalisation and thus is much more closely integrated into the international division of labour than many of its peers.
• In addition to the deepening trade integration, German companies have engaged in offshoring and outsourcing to Central and Eastern Europe.
• Finally, many corporates have also restructured their domestic businesses over the last decade, making use of company-specific wage deals and the like.
All of these efforts were needed to reverse the labour cost explosion on the back of reunification and allowed Germany to regain price competitiveness under the single currency.
No Fuelling the Debt Addiction Either
The last 10 years also saw a gradual deleveraging process for households and corporates, which has left balance sheets stronger than in the last recession. The absence of a housing boom has taken away one of the key factors denting activity elsewhere in the euro area. While Germany was hit hard by the financial crisis, the impact came mostly through its foreign financial engagements (as a current account surplus country, Germany exports capital via a number of different channels). But, contrary to other countries, it does not have to deal with an asset bubble in its own backyard.
And an Expansionary Policy Mix
The upside revisions to our German numbers are broad-based. We made very meaningful upgrades to our estimates for consumer spending, investment spending (outside construction), and export demand. Note that these changes come on the back of revisions to past data and the stronger-than-expected 2Q outcome and, as such, largely reflect the goods times of the past. When it comes to the full-year estimates, we know about 80% of the full-year estimate, having data for 2Q at hand (see European Economics: A Practitioner's Guide, June 4, 2010 for details on how the different quarters affect the full-year estimates).
Investor Focus to Shift Towards 2011 Soon
The remaining two quarters of 2010 will have a more meaningful impact on 2011 full-year estimates than they will have on 2010. This is because they determine the entry point into 2011 and hence the carried-over growth. Once investors come back from the summer holidays, they will likely start to focus on 2011, too. Unfortunately, 2011 will likely bring a meaningful moderation in growth in Germany and a more modest one in the euro area. Forecasting a deceleration in growth in 2011 remains one of our core out-of-consensus calls. Official forecasters, such as the ECB and European Commission, as well as the majority of other market economists, are still projecting an acceleration.
The European Export Motor Is Roaring...
Exports of goods and services gained a sizeable non-annualised 8.2%Q during 2Q10 (which translates to an eye-watering pace of nearly 35% in annualised terms). Again, a considerable part of the bounce is due to catch-up. Compared to last year, exports of goods and services are now up 18%Y. The biggest contributions to the rise in overseas demand for German merchandise, totalling 28%Y in June, came from the rest of the European Union (which accounted for half of the export growth), followed by Asia (which at 6.9pp accounted for a quarter - half of which is down to China). The US only added 2.4pp. Emerging markets clearly outweighed the euro area (at less than 5pp) and the US in terms of the contribution to export growth. However, several indicators suggest that the pace of foreign demand growth will moderate going forward. Export expectations for the next three months show signs of peaking out. The same seems to be true for the foreign order inflow despite the June surge. In addition, slower activity abroad and a renewed strengthening of the EUR should limit further gains.
...but Domestic Demand Stirs Too...
The noteworthy surprise within the strong 2Q report was that the strength was somewhat broader than we had expected. Domestic demand dynamics surprised on the upside as both investment spending and consumer spending recovered more than expected.
...as Corporate Spending Recovers Further...
Repeating the strong 1Q print, investment in machinery and equipment soared 4.4%Q. The sharp rise reflects partly the bounce-back in the industrial sector, but it is also propelled by a catch-up from massive cutbacks during the recession. The surge in construction investment is largely weather-related, we think. Interestingly, the inventory cycle only added a meagre tenth of a percentage point to headline GDP growth. While companies are still in restocking mode, according to the business surveys, which show that companies view their inventories as increasingly insufficient, the pace of the restocking process seems to losing momentum. In this context, we would emphasise that it is the change in inventories that determines the contribution of the quarterly GDP growth. Hence, the restocking process would need to accelerate quarter after quarter.
...and Consumer Spending Rebounds Too
Factoring the upwardly revised retail sales released late last week, consumer spending gained a stronger-than-expected 0.6%Q. At an annualised rate of 2.4%, this marks the strongest quarter since autumn 2008 and the first meaningfully positive growth in a year. While consumers had been holding back on big-ticket items thus far - as they were cutting back post the car-scrapping schemes - they were confident enough to reduce their savings recently. Despite the marked sequential gain and upward revisions to prior quarters, 2Q consumer spending still stands 0.7% below the level recorded a year ago. As the base effects reverse sharply in 2H10, the full year now seems on track for a small expansion. Previously, we had pencilled in a marked contraction, largely on deep declines reported initially for 2H09.
Labour Market Is a Key Driver of Consumer Dynamics
During the crisis, the German labour market held up well as companies asked employees to go part-time instead of letting them go. This labour hoarding is partially down to the short shift subsidies, which at the peak were paid out to 1.534 million workers, and partially down to concerns by companies about talent availability. Payrolls have proven relatively robust and are now expanding again at a monthly rate of 30,000 workers (equivalent to an annualised rate of around 1%). Going forward, employment prospects are brightening as companies' hiring intentions are up sharply and consumers' unemployment worries down steeply. As part-time workers on short shifts went full-time again and, in some cases, even took overtime, compensation per employee recovered meaningfully in 1H10. Notwithstanding trade union demands for higher wages now that the economy is past the worst, we would expect moderation in compensation growth going forward as the impact from the rise in hours worked peters out. On the whole, we believe that moderate payroll expansion, concerns about the pension system, and the absence of positive wealth effects suggest a relatively timid consumer recovery.
Budget Deficit Deepens but Less than Expected
The fiscal deficit of all layers of government (including social security bodies) deepened in 1H10. The budget balance, based on Maastricht definition, came in at -3.5% of GDP for the first six months of the year. Testament to the expansionary fiscal policy stance, revenues were still down 1.5%Y over the first six months and expenditures up 3%Y over the same timeframe. Our upwardly revised full-year growth forecasts, together with a better-than-expected outcome for 1H, cause us to lower our budget deficit estimate from 5% to 4.1% of GDP. Now that policymakers are coming back to Berlin after the summer recess, we will be watching closely for any signs that the German government is wavering on the budget savings it has planned for next year. This is because Germany acts as an anchor for the funding costs across the euro area and because it needs to comply with the requirement of a new constitutional debt brake, which prescribes a balanced budget by 2016. The first step towards implementing this small austerity package will be the Cabinet decision on September 1.
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