My thoughts on weakness in Europe and China
I am back from my summer holiday. There has been a lot of news in the time since I last posted. And the news flow is coming from a lot of different places. So, let me start up again with a post highlighting what I think are some of the key macro issues in a number of countries around the world. I intend to follow this up tomorrow with a post updating you on my ten surprises for 2014 and how they are faring so far.
Germany. Let’s start with Europe, and more specifically Germany, as Germany turned in a 0.2% economic contraction in Q2 2014. The German economic paradigm for over a decade has been one in which wages are suppressed in order to increase export competitiveness and enable economic growth. The upside of this approach has been a trade and current account surplus which adds to GDP figures. The downside is weak domestic demand that holds back GDP growth and a current account surplus that is so wide that it has now become the largest in the world and attracted negative headlines as a result.
In a world that decelerates, Germany is vulnerable. We saw this during the financial crisis when German output tumbled at the worst rate since the Bundesrepublik began. And we are seeing it again now. In the first instance, the German export growth was a vendor financing policy that caught the Germans out when the periphery went into crisis and their demand for German goods plummeted. But since then, Germany has turned elsewhere, to China in particular. I suspect some of the 2nd quarter weakness in German growth is due to residual impacts of China’s slowing through Q1 2014.
When I predicted Spain would outperform Germany for 2014 in February I wrote that “German domestic numbers are weak. Foreign trade is driving growth. This is Germany’s Achillees heel, especially with emerging markets slowing, the US slowing, and the periphery still weak. Spain is benefitting from lower yields, which will pass through into credit growth at some point this year, increasing Spanish home prices. And rising bad debt will stabilize, further improving the situation. Bottom line: Spain has a basing effect to work from.”
The call here was more upbeat on Spain but it was also a word of caution about Germany’s vulnerability. Since that time the situation in Ukraine has added more vulnerability for Germany. I believe we will continue to see weakness there.
Spain. Here are a few of the recent data points that have come out of Spain over the past few weeks.
- Bad debt between companies is at a record low (link in Spanish)
- Spain grew at the fastest rate since 2007 in the latest quarter (link here)
- Foreign investment is increasing, importantly in property (link in Dutch about Belgian interest)
- Spanish manufacturing is outperforming Germany, France and Italy (link here)
- Spanish two largest banks are in good shape relatively speaking. Santander is buying assets (link here)
All of this has the Germans even claiming that “Spain could become the next Germany” (link in German). You know it’s a compliment when the Germans are saying you could be just like us!
Snark aside, I think what they are getting at is that Spain is competitive now. And when you add in the basing effect that a depression with 25% unemployment creates, it means economic growth. July production in Spain declined, so it’s not all smooth sailing. Nevertheless, I believe Ireland and Spain will outperform and continue to expand without new extreme economic shocks.
Italy. I have written a number of times in recent months that Italy is the weak link in Europe now. This is for a number of reasons. One, the Italian economy is the third largest in the Eurozone behind Germany and France. That means weakness there is important. Second, the Italian macro numbers are poor: GDP at year 2000 levels, poor demographics, government debt to GDP closing in on 140%, decade-long declining low nominal GDP growth at best, no real structural reform. Italy is a ticking time bomb for Europe because one more recession that negatively affects the financial sector will mean serious government debt, major investor losses and renewed concern about Italy’s solvency.
Italy is now in a triple dip recession. And the Bank of Italy had already slashed economic forecasts before we got this news. Interestingly, the central bank projection of Italy’s GDP growth rate for 2014 came down to 0.2% in July from its January forecast of 0.7%, while it actually raised its 2015 forecast to 1.3% versus 1.0% growth in January. I suspect we will see these numbers come down considerably. Also given that inflation is at the lowest level since 2009 at 0.3% year-on-year, nominal GDP growth will be very weak, meaning the debt to GDPP numbers will climb through 2015.
China. The stimulus play is on. Growth deceleration was large enough that policy makers felt compelled to step in and turn to infrastructure-based stimulus measures yet again to keep the economy under control. JP Morgan Asset Management is impressed enough with these measures that it is talking about selective recoupling in emerging markets and recommends buying Chinese assets.
The housing market is an Achilles heel here. First, despite the new looser environment and increased efforts by local governments to prop up prices, house prices continue to fall in China. Prices fell in 64 of 70 cities in July, making this a countrywide rout. Buy to let property owners have turned to the short-term rental market to avoid taking huge losses as more than one in five properties are vacant.
To my mind, this is prima facie evidence of both overbuilding and speculation. The buyers of these flats are not owner occupiers. Nor are they intentional buy to let investors. They are speculators, investing their wealth in residential property because prices have gone up. Now that prices are going down, we should expect demand to dry up in a hurry.
The capital flight has already begun. Just as Russians and Greeks were ploughing money into Cyprus and London real estate to protect their wealth, Chinese investors are doing the same. They are accused of driving up real estate values in Australia, Canada and the United States, particularly in California. If the housing market continues to sag as George Magnus expects, we should expect to see capital flight pick up. And that could help prop up frothy housing markets abroad. (Update 1323 ET: note a Wall STreet Journal article published after this post was published cites a government official that owned 33 properties including one in Canada).
I am going to leave it there for now without commenting on the US. I don’t think we are at a point where global growth has slowed enough to start worrying about a crisis. But cracks are forming, particularly in Europe. I expect some additional form of monetary support from the ECB in the coming months as a result. And this will forestall any immediate crisis if it is forthcoming. Even so, this cyclical recovery is closer to the end than it is to its beginning.