Euroland: Slower Growth for Longer

We cut our GDP growth forecast for the euro area by 0.4 pp for 2008, to 1.6%, and by 0.3 pp for 2009, to 2.2%. Business conditions in the euro area have not deteriorated as sharply as we had feared one month ago. Notwithstanding this welcome resilience, we think that the bigger picture is becoming more sombre by the day for continental European economies. We are not overly worried by the potential consequences of the ongoing slowdown in the US economy, even if it turns out that the leading economy of the world is actually falling into recession. The main transmission channel from the US to Europe is the exchange rate, and we believe that currency markets are already priced for a US recession and its effect on relative interest rates on both sides of the Atlantic. More worrying, in our view, is the renewed distress in the money and credit markets. While we do not think that the European banking sector is at risk from a systemic angle, we suspect that a mild form of credit crunch — mild in comparison with what is unfolding in the US and might soon break out in the UK — will take its toll on the real economy over a longer period of time than we had originally anticipated.

Uncertainty has a price ...

The most visible evidence of the financial market turmoil is the sharp widening of short-term spreads between the interest rate set by the ECB, i.e., the minimum bid rate for banks’ refinancing operations (‘refi rate’) and swaps or interbank rates. The most relevant market rate is the 3-month rate at which commercial banks lend liquidities to each other. As of December 5, the 3M Euribor/refi rate spread had risen again to 75bp, or 50bp above its end-July level. The fundamental reason behind these wide spreads is the uncertainty that has emerged since July about the ‘fair value’ of structured credit products, whether they include layers of US sub-prime mortgage loans or not: a wide range of credit products is now treated with the same suspicion. Bank executives may have good reasons to think that the assets in their books (or their ad hoc subsidiaries, conduits or SIVs) are reasonably safe, but they must acknowledge that illiquid markets cannot provide reliable prices for these instruments. Not knowing the value of their own assets, these executives are unlikely to give the benefit of the doubt to their competitors, who are also their partners in the money markets. Seen from a macro angle, the Euribor spread is the price that markets are tagging on the uncertainty surrounding the assets held by credit institutions or, put differently, on the size of the assets that banks may have to write off in the future.

… which is a cost for the real economy

Higher financing costs are bad news for credit institutions, which already had to make sizeable write-offs. This would be only a microeconomic issue if it happened to another industry. However, credit institutions are different animals: their main macro function is to fund companies and households. Since banks have immediately and fully passed the rise in their funding costs onto their customers, the price of higher uncertainties has immediately yielded a higher cost of borrowing for the non-financial corporate sector. In addition, banks seem to have switched from a market share strategy, aiming at increasing the volume of their loan books to a credit quality strategy, in order to reduce their exposure to default risks. This was reported in the September bank lending survey made by the ECB. The combination of these two factors is unavoidably leading to a form of credit crunch, we think. To be fair, the growth rate of outstanding loans to the private sector is still quite robust, at 11.2%Y in October, and has not slowed since August. In our view, this apparent stability is the result of two opposite forces: tighter credit conditions and stronger demand, as non-financial companies or non-monetary financial intermediaries knock at the door of banks, given the persistent illiquidity in commercial paper markets.

Entering a soft patch in 2008

Taking stock of these developments, we anticipate a soft patch in the middle of next year, when the credit crunch reaches its climax and the lagged effect of the oil price spike, the overshooting of the euro and the US slowdown converge to weaken both internal and external demand. Within domestic demand, our view is unchanged: because the (relatively) indebted agent in the euro area is the corporate sector, the credit crunch should harm corporate spending (inventories and capex) more than it should hamper consumer spending. In addition, the personal saving rate in the euro area, standing at 14.1% in June 2007, is providing a comfortable cushion if the credit crunch spills over to the consumer sector. Even though we continue to think that euro area economies will likely re-accelerate as soon as companies start to anticipate a rosier economic outlook for both demand and profits, our gloomier view for next year is translating into significantly lower GDP forecasts for both 2008 and 2009.

Would a US recession change the outlook? Not really…

Our new forecast is assuming a serious slowdown in the US, with GDP growth around 1.5% next year. We believe that a weaker outcome, say 1%, including two consecutive quarterly contractions of the US GDP, would not significantly alter the euro area outlook. Since exports to the US take only 2.4% of the euro area GDP, a one-point reduction in US GDP growth would cut GDP growth in the euro area by around 0.05%, assuming that US imports would slow twice as fast as US GDP would. Accordingly, a 0.5% cut in US GDP growth would have a negligible impact on Euroland growth through trade links. However, past episodes have shown that the main transmission mechanism from the US was the exchange rate, itself largely a by-product of the long-term interest rate differential. In this regard, we think that the markets are already priced for the worst:

… because markets are already priced for a US recession

According to our colleague, George Goncalves, markets are pricing a 90bp rate cut by the Fed by the end of April 2008, while they anticipate that the ECB will stay on hold in the meantime. Since these expectations are already embedded in the dollar and euro yield curves, we believe that the current negative spread between US and German 10-year bond yields (UST at 3.91%, Bund at 4.03% as of December 5) is already pricing in a recession in the US, but not in the euro area. This has a crucial implication: at 1.45/1.50, the EUR/USD rate is also pricing in a mild recession in the US, which implies that the euro should not shoot up further if this hypothetical recession became reality.

Difficult decisions for the ECB …

Seen from the ECB’s vantage point, the mix between growth and inflation that we anticipate next year will be challenging. Growth will likely fall below trend and inflation will likely remain rather elevated well into the second half the year. The inflation outlook clearly takes precedence for the ECB, according to its mandate. It will be more important than the growth outlook, at least as long as inflation is still in overshoot territory and as long as the risks to price stability are on the upside. On balance, we therefore expect the ECB to remain on hold at 4% next year. However, there is clearly a chance of monetary easing next spring. A refi rate cut could become a reality, we think, if the credit crisis takes another major turn for the worse or if the euro significantly breaks above 1.50 versus the US dollar.

… if it wants to be true to its mandate

However, it is important to bear in mind that contrary to the Federal Reserve and the Bank of England, the ECB’s tightening campaign brought euro policy rates to a broadly neutral level, not a restrictive level. The need to ease monetary policy is therefore less pronounced for the ECB than, say, the aforementioned central banks, we think. In addition, domestic demand growth — notably consumer spending — in the euro area has not been driven by debt dynamics to the same extent as in the US or the UK. Much will depend on whether, in the view of the Governing Council, the recent rise in energy and food prices, which pushed headline HICP inflation up to 3%Y in November, could translate into so-called second-round effects via higher wage demands. The emergence of serious second-round effects would likely force the ECB’s hand. In our view, the robust labour market dynamics and the rising role of minimum wages will cause wage inflation to pick up to 2.7% next year, the highest growth rate since 2001. If we are right, vigilance is likely to remain a popular word in the ECB’s rhetoric.

Sharp deterioration could trigger rate cuts

While we do not rule out an ECB interest rate reduction in the course of the next six months, we believe that the dataflow will have to deteriorate considerably before interest rates cuts can be considered a base case scenario. So far, activity indicators do not point to a pronounced shortfall of growth below trend. We therefore would probably need to see business sentiment falling to — and eventually below — its long-term average. In addition, money and credit statistics, as well as the ECB’s own bank lending survey, would need to convince council members that credit conditions for investment in physical capital, such as machinery, equipment or structures, have become overly tight. Last but not least, well-anchored inflation expectations, as well as moderate wage demands, would need to signal to the ECB that the current overshoot in HICP inflation is likely to remain temporary. However, the starting point of the ECB’s deliberations is that cyclical inflation risks have emerged in the course of the last 12 months, which would warrant further tightening if it were not for the uncertainty and the downside risks to growth created by the current credit market crisis.

Bond yields to rise to 4.5% and beyond

Against the backdrop of a renewed economic recovery the second half of this year, rising long-term inflation expectations and higher near-term uncertainty, we expect 10-year Bund yields to rise significantly above 4% in the course of 2008. Our year-end target is 4.5% for 10-year government bonds. The yield curve is expected to steepen in a bearish move from its relatively flat shape now. The steepening in the euro yield curve could become even more pronounced in the event of ECB refi rate cuts. Overall, 2008 will likely be a volatile year for bond markets too, where investors will be torn between the downside risks to growth (bullish for bonds) and the upside risks to inflation (bearish for bonds). Additional risks to our yield forecasts stem from potential flight-to-quality on the back of another down-leg in the credit market and potential asset reallocation trades in the face of the first equity bear market since 2002. Both factors imply that we should not rule out that 10-year bond yields could also break the 4% level in the euro area in the first half of 2008. Nevertheless, at this stage, we believe that we have likely seen the lows in yields.

By Eric Chaney & Elga Bartsch London
Morgan Stanley
December 6, 2007