Evans-Pritchard - Eurozone recovery wilts as sugar rush fades, deflation lurks

by Ambrose Evans-Pritchard
The Telegraph
May 10, 2016

The eurozone’s short-lived recovery is already losing steam as stimulus fades and deep problems resurface, raising fears of yet another false dawn and a potential deflation trap if there is any external shock over coming months.

Industrial output fell in 1.3pc Germany and 0.3pc in France in March as manufacturing stalled, confounding expectations for robust expansion. The relapse in a string of countries suggests that flash estimates of 0.6pc GDP growth in the first quarter were too optimistic and may have to be cut.

“The recovery is not gaining any traction. I am really quite worried about another spasm of the debt crisis over the summer,” said Lars Christensen from Markets and Money Advisory.

“Markets are beginning to lose faith that the European Central Bank can deliver stimulus, and we are seeing the return of problems in public finances in Portugal, Spain, and Italy. That is becoming a key story,” he said.

The eurozone has been basking in a sweet spot over the last year, with stimulus from cheap oil, a weaker euro, ECB bond purchases, and an end to fiscal austerity, all coming together in a "perfect positive storm". “If that can’t produce growth, nothing will,” said Nouriel Roubini from New York University.

Each of these effects is losing its potency, or is turning into a cyclical headwind. Oil prices have jumped by 75pc since early February. The euro’s trade-weighted index has risen by 5pc over the last six months, and is now higher than it was when the ECB launched quantitative easing in a frantic effort to drive it down.

Looser fiscal policy has been too scattered and weak to galvanize lasting investment, and the initial sugar rush is now ebbing.

Marchel Alexandrovich from Jefferies said the ECB has so far failed to build a buffer against a deflationary shock. “What catches the eye is that services inflation has been running at just 0.2pc over the last six months. They are really not that far away from deflation.”

“Things are still holding up on the surface but people may be underestimating the underlying deterioration. What they need is a big programme of infrastructure spending, monetized by quantitative easing,” he said.

This could be done legally if the European Investment Bank issued bonds that were then bought by the ECB, a plan first pushed by Greece’s Yanis Varoufakis.

Professor Paul de Grauwe from the London School of Economics said QE may keep the cyclical wolf from the door for another year but this is no solution in itself. “It is not enough to sustain growth,” he said.

“We need an investment expansion of 2pc to 3pc of GDP to reach lift-off, and it makes sense when you can borrow so cheaply. But to talk about this is heresy. You hit a brick wall. They think it is devilish,” he said.

His pleas were echoed this week by the ECB’s vice-president Vitor Constancio, who warned that central banks cannot hold up the sky alone and called for “growth-friendly fiscal policies” with reforms to keep the fragile recovery alive.

He said the world economy was prey to "secular forces" that have lowered long-term growth rates, making it even harder to overcome the deflationary hangover of accumulated debt.

There are plenty of trouble spots in sight. Italy is struggling to manage a banking crisis as bad debts reach 19pc of lenders’ balance sheets, while Spain and Portugal are both in political turmoil and flouting EU deficit rules – leaving it unclear whether the ECB could legally back them in a crisis under its rescue machinery (OMT).

Raoul Ruparel from Open Europe said Spain’s apparent mini-boom is driven by a burst of pent-up consumer spending that cannot last: “Corporations are still heavily indebted and they are not investing. I don’t see this recovery as sustainable."

The eurozone is in much better shape than it was in 2011 and 2012 before Mario Draghi had established full control over the ECB. Yet there is still no fiscal union, and calls for Eurobonds have been blocked by Germany, Holland, Finland, and Austria. Nor is there a genuine banking union to break the "doom-loop" between banks and sovereign states, each dragging the other down in a crisis.

“Sovereigns are still exposed to the catastrophic risk of shouldering the cost of a banking system rescue. What matters for markets is who bears the ultimate, catastrophic risk,” said Jean Pisani-Ferry, France’s Commissioner General for Policy Planning.

This is eurozone’s Achilles Heel. It is sure to be tested in the next global downturn.