Europe's recovery takes a backwards step

The eurozone economy stalled during the June quarter, with major economies such as Germany and Italy contracting. With unemployment remaining elevated and growing fears about deflation -- combined with dysfunctional credit markets and an ageing population -- it will take years before the eurozone recovery is healthy enough to warrant tighter policy from the European Central Bank.

According to Eurostat, eurozone real GDP was unchanged in the June quarter, missing market expectations, to be just 0.7 per cent higher over the year. This follows modest growth of 0.2 per cent in the March quarter.

Two of the three biggest eurozone economies -- Germany and Italy -- contracted in the June quarter. Activity in Italy has declined in 11 of the past 12 quarters, while annual growth in Germany moderated to just 1.3 per cent (Italy can’t blame its recession on the GFC, August 7).

The French economy -- the region’s second biggest economy -- was unchanged during the June quarter, to be 0.1 per cent higher over the year. By comparison, momentum is slowly picking up in Spain, although unemployment remains at an exceptionally high level.

The recovery -- and I use that phrase loosely -- remains frustratingly slow and there are precious few bright spots within the region. It will take years before the weaker eurozone economies approach their pre-crisis peaks and unemployment will remain at devastating levels for years to come.

With growth stagnating and threatening once again to contract, and deflationary fears on the rise, there will be mounting pressure on the ECB to once again open its bag of tricks and expand its quantitative easing program.

In June, the ECB became the first major central bank to cut rates below zero per cent. Its deposit rate, applied on excess reserves placed at the ECB by banks, was cut to -0.1 per cent.

It also announced a plan that would provide access to up to €400 billion of cheap loans, equivalent of 7 per cent of outstanding loans, to businesses and households (excluding mortgages).

Such measures were necessary given European businesses and households continue to deleverage. A lack of investment has characterised the modest recovery and remains a key risk to the economic outlook.

Lending to non-financial corporations fell by 2.3 per cent over the year to June, although the pace of deterioration has eased somewhat in recent months. By comparison, lending to households decreased by 0.6 per cent.

While excessive debt is obviously undesirable -- and some deleveraging necessary -- a lack of credit availability is similarly debilitating. The inability to borrow has been particularly difficult for small and medium-sized firms who disproportionately rely on credit markets for financing. A lack of liquidity, combined with insufficient demand and poor capital allocation, has created an environment that is hardly conducive to expansion.

Taking a backseat to the financial problems, an ageing population continues to weigh on employment and income growth and is certainly not making the recovery any easier. While this is an issue facing most developed countries, core eurozone countries are comparatively older than the likes of Australia and the US.

Structurally countries such as Germany and Spain are shifting towards a lower income environment. The effects of an ageing population may be so great in Spain that its economy may never exceed its pre-crisis peak.

The ECB will be fighting battles on a number of fronts over the next few years. The unemployment rate has eased a little but remains at an elevated level and austerity continues to be a hindrance to a number of economies.

However, its most difficult battle may be inflation, which eased to just 0.4 per cent over the year to July. The core measure -- which removes volatile items such as food, energy, alcohol and tobacco -- rose by 0.8 per cent.

Deflation is not an immediate concern but with significant spare capacity remaining throughout the region, it is unlikely that annual inflation will push towards the ECB’s inflation target of 2 per cent for a number of years.

For Australia, this latest data in Europe -- and also the dreadful real GDP data from Japan -- comes as a bit of a blow. Both regions are strong markets for our exports -- albeit dwindling -- with Australia exporting a range of intermediate goods that eventually end up in Europe via east Asia (Australia’s export potential is all in the supply chain, August 13).

The global outlook took a hit recently -- mostly due to a softer-than-expected first quarter from the US -- and these data from Europe will result in further downward revisions. The recovery in the eurozone remains fragile and it’ll take years before the region is capable of consistently healthy growth.

Germany should rebound somewhat in the September quarter but the outlook for both Italy and France remains subdued and they could be subject to another round of austerity to meet their deficit targets. Spain is improving but remains so far below its pre-crisis peak that it may never actually get there.