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.

German inflation drops in November

Based on the results of six regional states, German headline inflation dropped to 0.6% YoY in November, from 0.8% in October. On the month, German prices remained unchanged. Based on the harmonised European definition (HICP), and more relevant for ECB policy making, headline inflation decreased to 0.5%, from 0.7% in October, and stands now at its lowest level since February 2010. A quick look at the available components at the regional levels shows that the drop in headline inflation was not only driven by lower energy prices but also some tentative second-round effects on consumer goods and a drop in prices for vacation destinations and package tours. Looking ahead, the recent drop in energy prices – if sustained and if not offset by strong currency weakening – could push German headline inflation further down. Corrected for the euro depreciation vis-à-vis the US dollar, oil prices have dropped by more than 15% since last November. Not all of this price drop has yet been passed through to consumer prices. However, as German employment just reached another record-high in October, this drop in inflation should be inflationary rather than deflationary. Just think of Draghi’s famous words “with low inflation, you can buy more stuff”. At the current juncture, price expectations of both consumers and producers remain solidly anchored in Germany. According to today’s economic sentiment indicators from the European Commission, price expectations by both consumer and producers have slightly come down in November but remain close to their respective historical averages. Interestingly, price expectations in the service sector have now increased for three months in a row and are close to all-time highs. This might be the result of higher wages and maybe also the introduction of the minimum wage. For next week’s ECB meeting, today’s German inflation data could be the prelude of another downward revision of the ECB’s inflation forecasts. Back in September, ECB staff had projected an average inflation rate of 1.1% for 2015 and 1.4% for 2016. Even without any significant changes to the growth outlook, the latest drop in energy prices should be sufficient to automatically lead to lower inflation forecasts. Remember that last month, ECB president Draghi had described two “contingencies” for further action: the current measures are not enough to reach the new (soft) balance sheet target, and a worsening of the medium-term outlook for inflation. Obviously, next week will be too early to give an assessment on the first contingency but with lower inflation projections, one of the two lights needed to start QE could already be lit green next week.

Abracadabra from Brussels?

Today, the European Commission will present its long-awaited investment plan. Risks are high that it will not be the big game changer.

It has probably been Brussels’ least guarded secret of recent weeks: Jean-Claude Juncker’s investment initiative is supposed to give the new European Commission and the entire European economy a kick-start. A ballpark figure of around €300bn has been circulating for a while. Today, the European Commission will present its plan on how to achieve the targeted amount.

Based on the available information circulating in the media, Juncker's plan should consist of a new investment fund that will give guarantees for private sector investors. The funds own financial means could be around €21bn, according to latest reports, €5bn from the EIB and €16bn from the EU. These guarantees should – in theory – attract almost €300bn of venture capital and private funds for projects identified by the European Commission. The focus of these project will be on infrastructure, energy and high-speed internet.

In our view, this means that hardly any new public money will be invested. The EU funds will very probably come from existing budgets and projects and whether the EIB’s €5bn will be new guarantees or only specially devoted funds remains unclear. Public funds will only be used as “first loss” guarantees. This means that without private sector money, not a single euro will be spent.

As regards the now known technical details, the biggest problem is of course the wished for multiplier. Making €315bn out of €21bn would make any magician jealous. The current construction would indeed cap the risk and therefore increase interest from private investors. However, the problem in our view is the expected return (or yield) on these investments. The identified projects are typical "public goods" projects, where it is hard to calculate an expected yield on the investment. However, this yield is what private investors will be looking for.

With the current low levels of interest rates, it might have been easier for governments to borrow money in the market rather than fixing and promising expected returns on investment for private investors. But to allow for that, one would need another change in the stability programme, effectively keeping investment expenditure outside the current expenditure budget, something Germany is most likely to resist.

All in all, it looks as if Juncker’s plan will not be the big game changer but rather a non-starter. Unless magic is joined by a miracle. As so often in the past, this would transform an excellent idea ultimately into a missed opportunity. To be clear, it should not be the Commission that has to be blamed, but the willingness of member states to chip in fresh money. As long as the Commission – or, for the sake of simplicity, Europe – does not have own funds, any financial attempts to revive growth are deemed to fail. This would be a pity as the underlying idea is good: find European projects and start investing to stimulate short-term growth but also, and more importantly, potential growth. This could have been the kick-start for the new Commission and the boost for new European growth visions, but instead Europe seems to have a new fund of hope rather than one of hard commitment.

Downward slide continues

Downward slide continues. German business confidence dropped for the sixth month in a row in October, illustrating the Eurozone’s biggest economy has reached a dangerous stage between soft spell and longer-lasting almost-stagnation. Germany's most prominent leading indicator, the Ifo index, just decreased to 103.2, from 104.7 in September. Both the current assessment and the expectation component slowed down. Particularly the weaker expectation component, which dropped to its lowest level since December 2012, is a reason for further caution. Latest soft data has rather increased than decreased the degree of diffusion, maybe even confusion. While last week’s PMI and consumer confidence indicator had given hope that the economy would slowly recover from the psychological shock waves from the summer, today’s Ifo index is less encouraging. Trying to get some grip on the current state of the economy requires a lot of instinctive feel. At the current juncture, it is still hard to tell whether solid domestic demand can offset weaker industrial activity; and if for how long. While the strong labour market and low interest rates are supporting private consumption and the construction sector, the export-oriented industry is still going through a dry spell. However, the latest reductions in backlogs and optimism stemming from new Chinese bulk orders show that the risk of drying-up is still relatively small. Looking ahead, Germany’s export industry will face several opposing trends in the next months: on the negative side, with France and Italy stagnating, demand from the Eurozone should remain weak. On the positive side, however, the strong US recovery and renewed demand from China bode well for exports. In our view, the German economy is neither near the abyss, nor close to a period of self-complacent honky-dory. It is in a longer-lasting transition period from the end of the positive reform cycle to the challenges an ageing economy is facing. Even if it is does not make sense to use single economic data as a barometer on whether or not the government will decide on growth-enhancing measures, the general need for more domestic investment in Germany remains. Last week’s European Summit, which took place off markets’ radar screens due to the stress test excitement, did not provide any further guidance. While statements in the final summit conclusions like “…the urgency of the prompt implementation of measures to boost jobs, growth, competitiveness…” sounded promising to those hoping for additional fiscal stimulus, the Germanic sentence “structural reforms and sound public finances are key conditions for investment” underlined that the face-off between Germany and the rest of Europe on how to revive the Eurozone economy is far from being solved. In the short run, lower energy prices and the weaker euro exchange rate are already a small stimulus package for the German economy. However, it is a package which will rather delay than advance new structural reforms.