Ifo signals conciliatory year-end

Conciliatory year-end. German business confidence confirmed the decent rebound of the economy in the final quarter of the year. Germany's most prominent leading indicator, the Ifo index, just increased for the second month in a row to 105.5 in December, from 104.7 in November. While the current assessment component remained unchanged, expectations increased to 101.1, from 99.7 in November. A rather disappointing year for the German economy comes to an end. The impressive growth performance of the first quarter was more than offset by a subsequent soft spell, which took longer than expected. The former growth miracle had quickly lost its glamour. With an average quarterly growth rate of 0.2% since early 2013, the German economy has morphed almost unnoticed from the Eurozone’s splendid growth engine to one-eyed in the land of the blind. In recent weeks, some of the worst concerns have subsided, though not disappeared. The Ukraine-crisis has calmed down, without being solved; the rest of the Eurozone should continue to recover, albeit at a too low pace; and the negative impact from the timing of the summer vacation has finally disappeared. Even better, lower energy prices and the weaker euro should make a decent short-term stimulus package for the German economy. As experienced in the past, the German economy is one of main beneficiaries from lower energy prices and a weaker exchange rate. Over the last twenty years, German exports to non-Eurozone countries have shown a rather unique correlation with exchange rate movements. Relatively immune against currency strengthening but strongly benefitting from currency weakening. A lucky pattern not all Eurozone countries have experienced. This positive effect should start to kick in in the coming months. Moreover, lower energy prices have already boosted every German’s disposable income by 25 euro per German. Last but not least, the fact that next year several public holidays will fall on weekends should add some 0.2%-points to GDP growth. Currently, probably the two biggest downside risks to a rosier German near-term outlook are Russia and complacency. As regards Russia, German exports to Russia have already suffered under the sanctions and the Russian slowdown, currently standing 22% below last year’s level. The current ruble crisis should now have a broader impact on German exporters as it should also affect products that did not yet fall under the sanctions. Even if Russia currently only accounts for roughly 2.5% of all German exports, direct and indirect repercussions from the current ruble crisis cannot be excluded. As regards the second risk, a recovery on the back of an external stimulus package also bears the risk of further self-complacency and a resistance to start new reforms. This year’s weakness provided further evidence that the economy is still too dependent on exports. Despite running at full employment and an almost closed output gap, private consumption has not been able to give a strong boost to the economy. Private consumption’s annual average growth rate between 2010 and 2014 almost doubled that of 2005-2009. However, at only 1% it was good but not good enough. The same holds for investment. With some slight upward momentum this year, it is still far too weak to close the gap with investment in most other developed economies, which widened between 1995 and 2009 when domestic investments grew by only 0.1% per year. There clearly is enough room for improvement. All in all, today’s Ifo reading gives a conciliatory end to an exciting but also disappointing year of the German economy. The economy once again defied premature swan songs. It’s now time to take a deep breath and enjoy Christmas, even if there is no reason for excessive backslapping.

More rebound evidence

More evidence for Germany’s rebound. October trade data just added to recent evidence that the Eurozone’s largest economy gained some momentum at the start of the fourth quarter. Exports dropped by only 0.5% MoM, from a strong +5.5% MoM in September. As imports dropped by 3.1% MoM, the seasonally-adjusted trade balance improved to 20.6 bn euro, from 18.6bn in September. The trade balance with Germany’s Eurozone peers was only slightly positive and exports to the rest of the Eurozone are only up 1.9% YoY. The fact that German exports to non-Eurozone countries are up by around 7% on the year illustrates the economy’s gradual decoupling from the rest of the Eurozone. German exporters are normally amongst the main European beneficiaries from a weaker currency. Interestingly, over the last twenty years, German exports to non-Eurozone countries have shown a rather unique correlation with exchange rate movements. Relatively immune against currency strengthening but strongly benefitting from currency weakening. A lucky pattern not all Eurozone countries have experienced. The exchange rate channel remains in our view the strongest argument for the ECB’s QE efforts. Indeed, going back to bigger macro-economic simulations indicates that ECB president Draghi was right in pointing to the negative impact on inflation from lower oil prices, rather than any positive effects for growth. As a rule of thumb, a depreciation of the (trade-weighted) euro exchange rate by only 5% could add some 0.3%-points to Eurozone GDP growth. To get the same impact from oil, prices would need to fall by at least 50%. At the current juncture, the weakening of the trade-weighted exchange rate has been less accentuated than the weakening vis-à-vis the US dollar. If it stayed at its current levels throughout 2015, the nominal effective exchange rate would only be 2.5% below its 2014 average. This seems to explain why ECB president Draghi prefers to use falling oil prices as a means to get QE, rather than hoping for the direct healing impact from oil. Looking ahead, even if it might hinder new structural reform efforts, a weaker euro is probably the best thing that could happen to both Germany and the Eurozone.

German economy makes good start into Q4

The end of the soft spell? German industrial production continued its rebound and increased by by 0.2% MoM in October, from 1.1% in September. On the year, industrial production was up by almost 1%. The increase was mainly driven by the production of intermediate and consumer goods. Moreover, production in the construction sector increased by 1.4%. Today’s data add to the encouraging data from last week when new orders increased by 2.5% MoM in October, after 1.1% in September. Even if the new order data might be slightly blurred by bulk orders, the latest positive trend from the industrial sector suggests that the initially weird sounding explanation of too many vacation at the same time during the summer was a valid reason for the economy’s weakening in the third quarter. Now that all Germans are finally back at work, the industry is rolling again. This is also confirmed by the fact the inventory build-up seems to have stopped in October. For the first time since June, inventories dropped again in November. Looking ahead, the German economy should benefit from a very special stimulus package. As experienced in the past, the German economy is one of main beneficiaries from lower energy prices and a weaker exchange rate. This positive effect should start to kick in in the coming months. Moreover, the fact that next year several public holidays will fall on weekends should add some 0.2%-points to GDP growth. Disappointing economic data since the summer months had given rise to a more general discussion about the state of the German economy. Were the numbers the start of a longer-lasting stagnation or just a soft spell? With today’s numbers the answer is clearly: a soft spell. And, even better, the soft spell should be over in the final quarter. Nevertheless, the economic rebound should not deviate from the fact that the German economy is exhausting the successful structural reforms from the past to the extremes. Even if the soft spell is over, self-complacency is definitely misplaced.

Draghi’s oil front against QE-opponents

Despite no action at today’s ECB meeting, president Draghi sent strong signals that QE will start next year. The inflationary number of Draghi using the word “QE” was probably the broadest hint he could give. The ECB’s macro-economic assessment has become grimmer. Particularly, the ECB’s view on growth looks much more pessimistic than three months ago. In its latest projections, ECB staff now expects GDP growth to come in at 1.0% in 2015 and 1.5% in 2016. Back in September, this was still 1.6% and 1.9%. The revision to the 2015 forecasts are probably the sharpest downward revisions within one quarter ever. Interestingly, the narrative behind these growth forecasts has not changed. The ECB still believes in a modest economic recovery on the back of domestic demand and the global recovery. Risks, however, remain to the downside. As regards inflation, the ECB sounded more alarmed. The fact that staff projections had been revised downwards seems to be the main cause for the following QE-signals. ECB staff now expects inflation to come in at 0.7% in 2015 and 1.3% in 2016, from 1.1% and 1.5% respectively in the September forecasts. These revisions reflect mainly lower oil prices in euro terms and the impact of the downwardly revised outlook for growth During the press conference, Draghi repeatedly used the lower inflation forecasts and the fact that energy prices had dropped further in the last two weeks as the main reason for concerns. In our view, the importance oil prices have received in the ECB’s current monetary policy discussions is a bit unclear. In earlier times, the ECB would have tended to ignore short-term effects from oil price fluctuations on headline inflation. Now, it seems as if Draghi is using oil as an argument to convince the last QE-opponents. However, it is remarkable that Draghi was relatively muted on the positive impact from lower energy prices on oil. Earlier this week, for example, IMF chief Lagarde had said that the current drop in oil prices could add 0.8% on growth in most advanced economies. The scene is clearly set for QE. Draghi’s comments during the Q&A could hardly leave any doubt: the ECB is determined to start some kind of QE in 2015. Here are the key sentences: According to Draghi, the ECB will “reassess the monetary stimulus achieved, the expansion of the balance sheet and the outlook for price developments. We will also evaluate the broader impact of recent oil price developments on medium-term inflation trends in the euro area. Should it become necessary to further address risks of too prolonged a period of low inflation, the Governing Council remains unanimous in its commitment to using additional unconventional instruments within its mandate. This would imply altering early next year the size, pace and composition of our measures.” Moreover, the slight change in tone that the ECB now “intended” and no longer “expected” the current measures to reach the size of the balance sheet from 2012 was the last evidence of the ECB’s determination. So, where does all of this leave us now? Here are the facts: the ECB will discuss QE in the first quarter of next year. In our view, this will not yet take place in January as too few new information will be available by then. As regards the balance sheet, we will get the second TLTRO on 11 December. Then, the run-off of the two earlier 3-year LTROs (accounting for roughly 280bn euro) could in the short run even reduce excess liquidity in the Eurozone. Moreover, the March TLTRO will be the first one where the take-up is depending on net lending and not the loan stock. Add to this the next staff projections and the ECB should have all information needed to go all the way. This makes us comfortable to stick to our current forecast of (an announcement of) a first intermediate QE in the first quarter, followed by sovereign QE in the second quarter, unless the Eurozone economy stages an unexpected growth revival. Obviously, not all ECB members, not even all members of the ECB’s Executive Board, are fully supportive on the role of the balance sheet in the ECB’s decision-making. However, the continued emphasizing of low inflation will make it very hard for even the purest Germanic monetarists to eventually block QE.