Crude And The Euro Breathing Space Will Be Crucial In Deciding If Eurozone Inflation Remains At 1.9%

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Francisco Vidal (Intermoney) | The next few days will be interesting as EU leaders confront the future of the European project, although they will also have to deal with the latest developments on Brexit, and no doubt dedicate time to US commercial belligerence.

American belligerence wrote a new chapter at the end of last week with a Trump tweet threatening new 20% tariffs on cars imported from the EU, unless the EU removed tariffs and restrictions he claims are suffered by US exporters. The threat is not new and came the same day as Brussels began implementing special tariffs on products imported from the US to the value of 3.2 billion euros.

These measures form part of the EU´s response to the US tariffs on steel and aluminium and focus on agricultural and other products which are sensitive in the key areas on which Trump depends electorally. The root of the problem lies in original tariffs imposed by the US which is leading Trump into a dangerous action-reaction loop created by his own decisions and which could result in the scenario of a trade war. In other words, a scenario in which the decisions taken could significantly disrupt world trade.

At the moment this remains a risk scenario for trade, even though the possibility is weighing on indices like the PMI manufacturing data which continues to show an erosion of confidence among industrial producers. According to the data for June, this index has fallen back to 55.0, and has done so in the shadow of: the slowest expansion in manufacturing activity since 2016, the lowest level of orders for nearly two years, highs in prices paid and a break on wages.

Those making up the PMI manufacturing index were none too favourable, and those interviewed drew attention to commercial problems and political uncertainty. Factors which, although no-one recognises it, may have less impact than increasing oil prices, which hit companies´margins. In any event, the reality is that the main futures indicator of the Euro zone continues downward, and the factors that weigh on it are seen also producing negative turns in the industrial confidence in the Eurozone (Thursday) and the German IFOs (Monday).

Nevertheless, in relation to the IFOs there is another factor which acts as a counterweight, which is that we are not dealing with an indicator which is purely industrial. The element of the IFOs reflecting service industries should be positive, reflecting the reboot to 55.0 in the Eurozone PMI for services published on Friday. This reboot is accompanied by advances in orders, employment and the ability to raise prices. This allows a more positive reading of the Eurozone PMIs, although it should not lead to complacency.

Firstly, the accumulated expectations of the Eurozone service sector are at 19 month lows and a clear factor explaining this is the tightness on the supply side. In many cases the lack of raw materials and qualified personnel is questioning the capacity to increase production, which is worrying. Thus the revival in service sector Eurozone PMI in June may have benefitted by comparison with May, where production was reduced by holidays.

In short, although the slightly better performance of the PMIs and their levels (growing 0.5% per quarter in the Eurozone) is good news, we should not pass from concern to complacency. Over the next few days we will see the Eurozone confidence data published by the European Commission, which will also show a certain improvement for the service sector, but also downturns in the industrial index, and will confirm the deterioration for consumers.

However, the levels will continue to remain solid, like the German Gfk, whose backward step in July will not be relevant.

German confidence figures remain high, thanks to a labour market matched to a situation of full employment (as recorded in Friday´s figures) and the increase of 3.5% in disposable income in the 12 months that ended in Q1 2018. Consumption therefore should increase, although the downturn of -0.7% in German retail sales in May appears to question this assumption. Nevertheless, the shift of German spending towards services should be taken into account, and that sales will normalise their strong recovery of 1.6% in May.

Eurozone consumption figures are not limited to Germany. In Spain we see advances in retail sales and in France the April downturn in manufacturing spending has been left behind. However, these references are of secondary importance with the markets expecting the preliminary inflation figures for June for the main members of the Eurozone, as well as the comparative rates for the area. Oil prices and the break offered by the Euro since the middle of April, will be key to whether the Eurozone inflation rate remains at 19%.

Actually the key is not so much the current data but rather future expectations. The confirmation of the convergence between the trend in inflation with the expectations of the ECB will depend on the final end of QE. For now, the reaction of crude prices to the OPEC Summit, with increases of over 5% in WTI and 3% in Brent, suggest that oil will continue to play in favour of global inflation.

The OPEC Communique, to avoid embarrassing Iran, did not establish an exact figure for the increase in production, although in the best case, and at the expense of the agreement with the non-OPEC producers, we could see an increase in production of 1mbd over current levels. In practice, the figure could be less, amounting to about 0.7 – 0.8 mbd.

The OPEC countries simply agreed that from 1 July they will complete 100% of the adjustment to production agreed in November 2016 (-1.2 mbd) and no accept levels of fulfilment of 152% as those of last May. In fact, according to secondary sources, OPEC production in May reached 31.87 mbd, as opposed to the self-imposed limit of 32 mbd.

The point is that the bulk of the decline is explained by Venezuela which produced 1.39 mbd instead of its quota of 1.97 mbd, although this was obscured by the greater production by countries like Iraq and Iran. Therefore, unless Venezuela improves its levels of activity, which seems unlikely, the effective output increase of OPEC and its allies outside the cartel could remain below the 0.7 – 0.8 mbd suggested above.

So, in the short term, oil prices will be sustained, and with them inflation in Europe and the rest of the world. Therefore the members of the ECB in their intervention next week could reaffirm their already stated exit strategy, pointing out the importance of having set out the shape of the route for the future.

Not everything within the ECB will be focused on the future of monetary policy. The Bundesbank has revealed that new directives will soon be known on the way in which banks must deal will problematic debts. Banking questions which will also be before the Council of Europe at the end of next week where new steps are expected. The EU Ministers of Finance will discuss ways of strengthening the role of the ESM in the next financial crisis, and decide whether it can offer loans to the European Banking Resolution Fund, in case this latter is left without resources.

However, once the maturities on Greek bonds have been delayed with the first coming due in 2033, the key issue will be following the discussions on Brexit, in the shadow of leaked documents recommending that the EU members prepare themselves for the worst case scenario.



About the Author

Francisco Vidal
Francisco Vidal is Chief Economist at Intermoney. Since 2006, his professional career has been focused on elaborating economic analysis for the group, which has become a reference for financial intermediation in Spain. This is a situation which has allowed him to specialise in the interrelationship between the real and the financial economy, as well as the study of monetary policy.