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Headwinds Ahead for the Eurozone

 

As we have measured the health of the European patient this year, we’ve anchored our thesis on a critical catalyst: employment.  We’ve held that Eurozone unemployment would rise into year-end and next year and that would create a grave headwind for the improving fundamentals that we’ve seen across multiple metrics and contribute to economic divergence between individual countries over the intermediate term.

Today Eurostat reported the Eurozone jobless rate rose to 9.6% in August from 9.5% in the previous month. The upturn came as no surprise: we’ve forecast a sequential rise in joblessness across the region as the part-time jobs that buoyed employment over the last months for numerous countries expire into year-end. This rollover occurs as employers, who under government pressure and inducements, opted for part-time contracts rather than outright layoffs face the choice of calling workers back full-time or not. As we move out in duration we’d expect the total rate to tack on at least another 100 bps as we enter the new year, with significant national divergence.  

Certainly a rise in unemployment should grind into economic performance, however we’ve yet to see this make an impact across all fundamental measures.  Importantly, forward-looking European confidence rose in September to 82.8 (the highest level in 12 months) and the manufacturing Purchase Managers’ Index rose in the Eurozone to 49.3, with manufacturing improving for the three largest economies sequentially:  German and Italian manufacturing improved to 49.6 and 47.6 but held below the 50 level signaling contraction, while the index for French manufacturing shot up to 53.0 from 50.8 in August, holding its level in expansionary territory.

Importantly consumer spending should deteriorate alongside sentiment as unemployment rises.  Although a lagging indicator, retail sales released this week for Germany fell 1.5% in August sequentially, an inflection point from July’s +0.7% reading. Further, Eurozone retail sales as measured by Reuter’s PMI held below the 50 level in August, with sequential improvement for France and Italy and a decline in Germany to 47.9.  

Eurozone inflation has also been a main focal point for us. September’s initial CPI reading of -0.3% year-over-year released this week was surprising directionally (if confirmed); we expected an incremental rise off of the August -0.2% number, as energy prices on an annual compare move the dial into (mild) inflationary territory. While we may need to push forward our timing slightly, the data suggests that food prices also drove the number deflationary.  This of course is a net benefit for consumers, who’ve also realized purchasing power with a strong Euro versus the USD.

Returning to our thesis that all European economies were “not created equal”, inflation is running a variant levels across countries. Spain measured -1% in September Y/Y, [from -0.8% in August Y/Y] while Italy recorded +0.3% in Sept. Y/Y. We continue to hold that German inflation should be flat to moderately positive over the next two quarters [from an initial reading of -0.3% in September Y/Y], a set-up we like as the economy returns to growth.  

The take-away here is that countries that were levered up into last year’s crash (like Spain or Ireland) should see deeper deflationary numbers (Irish CPI at -2.4% in August Y/Y), which should extend recovery on the TAIL (3 years of less) and put the ECB in a precarious position when it considers raising rates. 

All of this has led us to become incrementally more bearish on Europe’s advanced economies, many of which are faced with rising government budget deficits that will force them (in some cases) to cut public spending and raise taxes, placing additional downward pressure on economic performance on the TAIL. The IMF today issued its updated projections on global growth and forecasts the Eurozone to grow a paltry +0.3% in 2010, while Central and Eastern Europe should grow 1.8% and Russia 1.5% next year. The release suggests commodity producing countries and the emerging economies should drive global growth, with Brazil and Mexico forecast to expand 3.5%; the Emerging market and developing economies 5.1%; China 9.0%; and Developing Asia 7.3%. 

We’re currently long Germany via EWG in our model portfolio.

Matthew Hedrick
Analyst

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