Why Europe may atone for China

It would be an extraordinary ‘black swan’ event, but the eurozone economy could be on the verge of a strong upside surprise, which could more than offset any downside concerns from a slowing Chinese economy.

First a few basic facts.

According to the IMF data, total GDP in the European Union was around $US16.6 trillion in 2012 which is double the $US8.2 trillion from the Chinese economy.

In other words, a 1 per cent upside growth surprise in the eurozone GDP counteracts a 2 per cent downside surprise in Chinese GDP growth. The eurozone, in total, is about 5 per cent larger than the US economy.

Policy makers have been trying to turn the eurozone economy around with the European Central Bank setting rates near zero and pledging to do “whatever it takes” to promote growth and market stability.

The latest batch of good news from the eurozone came with the German retail Purchasing Managers Index, which rose to 56 index points in July to be at the highest level since January 2011. According to the survey of retailers, better weather and improved consumer morale were the key factors supporting the strong lift in retail sales growth. Encouragingly, the survey pointed to a “modest pace of job creation in July”.

The other more favourable news was a lift in economic confidence in the eurozone as a whole. The European Commission’s economic sentiment index rose to 92.5 points in July, to be at the highest level since April 2012. At the same time, the business climate index rose to a 15 month high.

While none of these surveys is, by themselves, a definitive indicator of the health of the economy, the fact that almost all of the recent news of the economy is pointing higher and generally exceeding expectations is a positive sign.

The ECB meets again on Thursday and while the market is expecting no policy change to be announced, the recent run of more favourable news is expected to see some slight upward revisions to the GDP growth forecasts and a more upbeat rhetoric from President Mario Draghi. 

That said, the eurozone is still a long way from normalising its economic position. GDP has fallen for six straight quarters and the unemployment rate recent hit a record high above 12 per cent. The level of government debt continues to rise (Time to slay the austerity myth, 23 July) although policy makers and markets alike have been very calm in recent months about the sovereign debt position.

The eurozone needs to return GDP growth to around 2 per cent before there can be sustained inroads in the unemployment rate. While the current trends are encouraging, further upside in a range of indicators is needed if the economy is to hit that pace of growth in 2014, which is why the market will be closely watching the European Central Bank meeting for guidance on the policy outlook.

At the ECB meeting in July, Mr Draghi for the first time outlined a longer run strategy for policy, pledging to keep interest rates low for as long as necessary to sustain the recovery or indeed to cut them further if required. 

Similar rhetoric this week, even with better economic news, will likely further support markets, including for bonds which had been vulnerable to ongoing problems with sovereign debt concerns.

The reassuring comments from Mr Draghi have been a key factor in promoting market stability. While there has been an occasional bout of bond market volatility in a few peripheral and problem countries, there is no sign of the market ructions that previously threatened to erode the broader policy settings. 

Helping sentiment earlier this week was confirmation that the International Monetary Fund planned to release the next €1.7 billion of bailout funds to Greece. The IMF noted that Greece had successfully passed its fourth review, which means that the threat of disorderly economic or financial market conditions from the most troubled member of the eurozone continues to recede. 

With better economic news from the two largest members of the eurozone – Germany and France – in recent months, there are grounds for some cautious optimism. Forecasting strong recoveries, like recessions, is always difficult but when conditions turn, forecasters are usually too conservative in their forecasts for trajectory of growth from the turning point.

It is too early to make the claim of a rapid recovery in the eurozone, but the odds are rapidly moving toward growth being stronger than anyone expected.