Watch the Second Derivative of Euroland Growth

July 24, 2008

It was no surprise that Euroland growth slowed in early spring.  Special factors like a mild winter had strengthened growth in 1Q08 to an unsustainable speed, and Europe faced numerous headwinds: tighter credit conditions, more expensive energy costs, weakening demand in export markets, and an overvalued euro.  Officials at the ECB have admonished market watchers to look at the first half of 2008 as a whole rather than focus upon second-quarter data.  So far, so good.  Activity in the region is slowing.  The first derivative of activity is negative as predicted and as deemed natural and appropriate.

It is the second derivative of activity, a quickening slowdown of growth, which causes private analysts to gasp and maybe ECB officials to rethink.  Without the economic imbalances of the United States, the consensus has been that Europe should experience a soft landing.  Data released today cast doubt on that.  German, French and Italian business sentiment figures dropped much more in July than assumed.  Germany’s IFO Institutes reported business climate of 97.5, a 34-month low.  Such had fallen only 1.3 points from March to 103.4 in May but then dropped by another 2.2 points in June and another 3.7 points in July.  The expectations component, which itself serves as a leading indicator of the entire index in coming months, fell by a combined 1.1 points between March and May and then by 2.6 points in June and another 4.6 points to a recessionary value of 90.0 in July.

Italian business sentiment slumped to an 81-month low of 83.5 in July, and June was revised downward another 0.4 points to show a 2.7-point drop from May.  Between March and May, the index had firmed by 0.3 points.  Consumer confidence in Italy has meanwhile plumbed to a 15-year trough, and Silvio Berlusconi’s third stint as prime minister is proving anything but a charm.  The self-serving leader of Italy’s political right is just as incompetent as he was during his earlier terms in office.  Over in France, business sentiment sank by another 3 points in July instead of just one as forecast to reach 98, ten points below its level four months earlier.  This measure is now below its long-term average and at a 38-month low.

Most importantly, Euroland’s composite PMI scored its second straight sub-50 PMI reading in July.  It was at 47.8, down from 49.3 in June, 51.1 in May and 57.5 in July 2007.  The orders component was at a 61-month low of 46.4, down from 48.0 in June, 49.8 in May and 58.1 in July 2007.  The manufacturing PMI was 47.5, lowest since June 2003 after 49.2 in June and 50.6 in May, and the services PMI was also below 50 with a score of 48.3 compared to 49.1 in June, 50.6 in May and 58.3 a year earlier.

When the dot-com U.S. recession of 2000-1 unexpectedly infected Europe and to a surprisingly strong degree, an expected downturn of the dollar failed to materialize, so the euro did not start its recovery path until 2002.  This time, Euroland is experiencing a brush with recession at a time of extreme euro strength, rather than extreme softness.  The ECB refinancing rate is 4.0%, just 75 basis points below its peak earlier in this decade, but the real central bank rate is much lower now than then — indeed at zero — because of much higher inflation.



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