Growth and inflation outlooks diverging

The near-term growth and inflation outlooks for the euro area continue to move along diverging paths. We expect economic activity to rebound in H2 even if downside risks to euro area exports remain as geopolitical risks escalate.

However, we have further revised down our inflation forecast to 0.4% y/y for July and 0.3% for August (below consensus). The very moderate nominal GDP outlook remains a major concern for public debt dynamics, especially for the highly indebted economies in the periphery and the semi-core.

EA economic activity: Temporary or persistent weakness?

Investors are trying to decipher whether the recent indicators of economic activity signalling a slow down in the euro area are temporary or, instead, could extend beyond Q2 2014. Shedding some light on this issue, euro area July “flash” PMIs hit a three-month high at 54.0 (+1.2 points), supported by the solid performance of the services sector.

Our updated PMI-based GDP indicator signals a +0.4% q/q Q3 GDP growth, in line with our growth forecast and suggesting that economic activity will rebound in H2 14.

Looking at the PMI details, the services PMI headline index posted the highest reading in more than three years and the manufacturing sector components remained broadly stable. PMIs continue to mask a strong divergence among countries.

In Germany, PMIs rebounded markedly in both sectors, and rising forward-looking components in the manufacturing sector suggest that industrial activity is likely to accelerate after the weak Q2 performance. In contrast, the June IFO business confidence dropped to the lowest level since October, somewhat below market expectations.

The soft readings of the July IFO business index survey signal a slight downside risk to our H2 GDP growth forecast (0.4% q/q for Q3/Q4 14). French PMIs – despite a rebound in July – are still lagging behind significantly. Although confidence jumped in the services sector in France, it remains well below the euro area average at 50.4 (vs. 54.4 for the euro area).

More worryingly, the manufacturing sector remained on a downward trend at the start of Q3, in line with the recent INSEE survey. For the periphery (Spain, Italy, Ireland), we estimate that PMIs edged down in the manufacturing sector, while they likely improved by 0.8 points in the services sector.

For next week’s GDP data releases, we expect that Spain Q2 GDP growth (Wednesday) accelerated to 0.5% q/q (see Growth and Employment improve in Q2, 24 July 2014). We retain the view that Spain is likely to sustain an average q/q growth rate of 0.5% in Q3-Q4, implying an overall growth of 1.3% for 2014. For 2015, we still project GDP growth to accelerate to 2.0%.

Public debt continues to creep up

Public debt data for Q1 2014 released this week showed how the vast majority of EA countries continue to accumulate public debt (in GDP terms) with only a few exceptions. Public debt in the EA has increased to 96.4% of GDP. All periphery economies have reached debt levels above the EA average: ranging from 174.1% of GDP in Greece and 135.6% in Italy to 96.8% of GDP in Spain.

In core countries, at one end of the scale, Germany continues to reduce public debt levels for the 7th consecutive quarter to 77.3% of GDP; at the other end, France continues to see its public debt rise, reaching 96.8% of GDP in Q1 14 (above the EA average).

Looking ahead, EA governments have designed further fiscal consolidation plans to be increasingly geared towards lowering spending rather than increasing revenues. Debt to GDP ratios will be improved by the adoption this year of the ESA 2010 accounting standards, which will raise GDP levels by 2.4% on average. At the same time, a weak nominal GDP outlook, on the back of very low inflation dynamics, will make the deleveraging process very challenging for highly indebted economies.

Inflation outlook: From bad to worse

We expect euro area “flash” HICP inflation (Thursday) to decline to 0.4% in July from 0.5% in June. Core inflation is likely to remain unchanged at 0.8% y/y. Risks surrounding our forecasts are skewed to the downside. We now expect euro area inflation to hit a new cyclical low of 0.3% y/y in August and September (versus 0.4% y/y previously expected), before it slowly increases from October onwards. The small downward revision to our short term m/m forecasts has not caused us to revise our projected average inflation profile for this year and next: 0.5% in 2014 and 0.8% in 2015.

Underpinning our euro area inflation forecast for July is the expectation that consumer prices have declined in Germany and Italy, edged up in France and remained broadly unchanged in Spain. We forecast German HICP (Wednesday next week) to have increased 0.2% m/m, consistent with an inflation rate of 0.7%, down from 1.0% in June. Italian HICP (Thursday) is projected to have declined 2.0% m/m, a fall that would take the inflation rate down to +0.1%, from +0.2% in June. Finally, we forecast Spanish HICP to have remained flat in July (Wednesday).

Credit crunch softening

M3 money supply rose by 1.5% in June after 1.0% in May. Lending to companies and households shrank by 1.7% in June after contracting 2.0% in May. The rebound in M3 growth and a smaller contraction in lending both signal that the credit cycle appears to be bottoming out.

We interpret this as good news for the ECB as the credit crunch to the private sector is softening. We expect M3 growth to accelerate further once the ECB’s new targeted longer-term refinancing operations (TLTROs) kick in (first operation in September), although not to the extent observed in 2012.