Summary: Despite the grandiose title of this post, I intend to keep my comments brief. Having had a few days to digest the news without having to write, I come back somewhat more optimistic about the European economy. I wouldn’t call myself a bull but I see the global upswing continuing through 2013 and into 2014. Below are some notes on specifics.
My recovery call is – if anything – looking too cautious. For about the last three months, I have been saying that Europe was moving toward recovery. Never did I say it was actually in recovery. So when figures came out earlier in the week indicating that Europe’s economy actually expanded in Q2 I was pleasantly surprised. The numbers more than confirmed my optimism on Europe.
To take step back, here is what I have been saying from about mid-May when I started getting more optimistic about Europe. The chronology of my comments was useful for me in looking at how the situation has changed. The chronology suggests that the move to backloading austerity was a positive catalyst which aided a bottoming process and has put Europe over the top into recovery mode earlier than anticipated. And note the post on second derivatives. That’s really important. Here are the best snippets:
- Europe’s sinking economy (15 May): “So the euro zone numbers are telling us that the austerity has been too great and that the European private sector needs some relief. I think we will get it as the relaxed austerity timetables are telling us. And so that means the economic outlook is not quite as dire as some would have you believe. At the same time in Greece, not only do I believe the debt deflation has largely played out but the ratings agencies are upgrading the debt, targets are being met and exceeded and bond yields are plummeting. This is a virtuous circle that makes me bullish on Greece in particular. I am only bullish on European equities to the degree that they are undervalued vis-a-vis North American ones. But the fiscal drag caps any upside. And I do not expect the ECB to come to the rescue.”
- On Greece’s eventual exit from the eurozone (21 May): “What is happening is that Greece’s economy is bottomING. The economy has not bottomED and will not bottom until 2014. However, the rate of decline has decelerated. And so markets are anticipating a better future in Greece. The Armageddon scenario has been removed from the table.”
- Europe is now officially in back-loaded austerity mode (29 May): “As I have ben predicting here for months, the problems in individual large European economies have become too large to bear for the prevailing European policy mix. Therefore, today, in releasing the next year’s country specific recommendations, the EC has moved away from front-loaded austerity, pushed back deficit reduction targets, and instead stepped up calls for structural reform. The pace of austerity is now considered to have been too swift – socially and politically unsustainable – and so timetables are getting pushed. But the paradigm remains the same – austerity and structural reform. The slant is now away from austerity simply in order to accommodate the facts on the ground.”
- Watch second derivatives in the Eurozone (3 Jun): “Despite the bleak situation, I see the data as positive because it is steadily moving toward growth. The numbers are ‘less bad’, meaning the contraction is less severe. Another way of saying this is that the numbers are getting better. The manufacturing PMI was the highest in 15 months, for example. And so the question has to be about sustainability. For how long will these numbers continue to improve?”
- On predicting the US and European cyclical economic outlook (3 Jun): “As I mentioned in the last post, the 2nd derivative is what I care about in terms of gauging cyclical turns. When it changes direction, that is significant. A 2nd derivative shift essentially says the economy has stopped growing as quickly or has stopped shrinking as quickly. If this directional shift lasts for more than 1 or 2 months, you have a pattern – and that pattern tells you that the top or the bottom is in. In Europe the second derivative is shifting from contraction to expansion.”
- The biggest worry in the global economy now is emerging markets, particularly China (20 Jun): “In Europe, I have been arguing for a while now that the maximum point of economic contraction is behind us. The economy is slowly moving toward recovery, one that I expect to take hold in the latter half of this year already. The European PMIs today confirmed the trend back toward recovery as output fell at the slowest rate in 15 months. Output is still falling, but I believe it will soon rise as nothing on the horizon suggests the data improvement trend will reverse. To be sure, many economies are struggling – and not just in the periphery; Finland has said it expects its economy to contract in 2013 for example. So we are not out of the woods by any stretch. Nonetheless, second derivative analysis tells me the trend is toward better numbers, not worse.”
- Some thoughts on Europe, most of them positive(8 Jul): “In sum, I have a constructive view of the European economy. I believe we will see recovery later this year. But I do not believe this recovery will be robust or necessarily sustained. And that makes it especially difficult for Greece and Portugal in terms of debt sustainability and political and social unrest. The likely outcome here is one of recovery in Europe toward the end of 2013, with recovery coming to Greece and Portugal later. This will be followed by weak growth and political and social frustration with the pace of improvement, making the outcome unpredictable. At some point, I anticipate a flaring of yields again, testing the political will of the policy elite. And of course, I eventually expect Greece to exit the eurozone due to this outcome.”
- Why I am relatively upbeat about Europe(24 Jul): “So Europe is not out of the woods by a long shot. Future sovereign defaults are still on the table and debt deflation is a problem. A lot of this could be cleaned up if Europe would just recapitalize its banks properly. But no one wants to do that because it means heaping yet more debt onto the sovereign when everyone including Germany is in fear of having still more sovereign debt – and no explicit central bank backstop. The Eurozone is trying to repeat Japan’s lost decade. That’s where this is headed using the current extend and pretend paradigm. At least we are seeing incremental moves toward recap, as in the case of Deutsche Bank earlier in the week. We have a long way to go though. Bottom line: Europe is moving in the right direction. The economy is moving toward recovery, policy is giving countries more breathing room, and banks are slowly being recapitalized. That makes me relatively upbeat about Europe over the medium term. Unless problems in China and the emerging markets spoil the nascent swing to recovery, the macro picture at the beginning of 2014 will look better in Europe than it did at the beginning of 2013.”
- The global cyclical recovery will continue(9 Aug 2013): “I think it means that Europe will be stronger economically than many anticipate. After years of waiting for a collapse of the euro zone, the uptick in the economy will be a well-needed respite. Nevertheless, while the economies of the periphery might improve somewhat, they are not going back to robust levels of growth. And while that’s a problem delayed, it’s still a big problem. Remember, these countries have high private and public debt levels, poor demographics, no ability to generate excess inflation and depreciate the currency and only a partial and implicit backstop from the central bank. A respite is nice. But it doesn’t mean the crisis is over by a long shot. Over the medium term I expect a few upside surprises. But eventually we will see recession again and by that time the same questions about eurozone breakup will be asked.”
Having read through this chronology, I don’t believe my macro view on Europe has changed. We still have a large private debt and undercapitalized financial sector overhang. Moreover, Europe wants to be more ‘responsible’, more hawkish than the Americans. That means less fiscal stimulus or more austerity depending on the country and it also means less support from the central bank. This policy mix is what has led to Europe’s underperformance and what will keep Europe underperforming over the medium-term. The question is whether there is any longer-term payoff for keeping this policy mix in place. I would say no because there are deadweight loss issues associated with what I would consider artificial scarcities and that leads to a significant loss of economic efficiency, especially via the increased volatility in the financial sector and the lack of interbank lending.
That said, the economy in Europe is now in a cyclical upswing and we will just have to see how long this upswing goes on and how long policy makers will LET it go on before they tamp down again with more restrictive fiscal or monetary policy. What is surprising in a positive way is that there are recovery signs nearly everywhere, including in Spain and Portugal. The places that are still losing output the most are Greece and the Netherlands. Italy is a push and Ireland seems to be OK. France and Finland, core countries with weakness, have shrugged off the weakness for now. And elsewhere in the core, the expansion is weak but helpful. Let’s watch the data flow, but for now, Europe is on the mend.