Since European Central Bank President Mario Draghi’s speech in late July promising to do “whatever it takes” to preserve the euro, followed by the announcement of an ECB program to buy short-dated peripheral government bonds under some circumstances, euro area markets have rallied and the single currency zone has faded as a source of concern for markets in the U.S. and elsewhere. Investors who earlier in the year were closely following the ins and outs of Greek coalition politics have turned their focus to other topics, in particular fiscal cliff negotiations in the U.S. While it no longer represents an imminent threat to global risk assets, however, the euro area crisis continues to unfold, and sooner or later it will return to the headlines. Indeed, bad news about euro area growth and renewed tension about Greece have likely contributed at the margin to the U.S. equity market sell-off in the past few weeks.
The coming months will likely bring a mixture of good and bad news about the euro area. The improvement in financial conditions achieved in recent months, if maintained, should help generate somewhat stronger growth for the region in 2013. That pickup in turn may represent part of a broader narrative of improving business cycle conditions outside the U.S. By contrast, the euro area’s institutional progress likely will remain fitful at best, leaving the region vulnerable to bouts of political disturbance and worsening sentiment.
For now, three moving parts within the euro area story deserve investor attention:
Financial conditions have improved significantly, but are now at risk. The ECB’s successive actions over the past year — especially the LTROs and more recently the yet-to-be-implemented OMT announcement — have by no means solved the euro area crisis, but they have done much to ease financial tension. Peripheral bond spreads have narrowed significantly (Chart 1), and both the Italian and Spanish governments have maintained their once-threatened access to the primary market. Euro area equities climbed more than 20 percent from late July to mid-September, though they did not quite return to their March peak. As a whole, euro area stocks this year have come close to matching the S&P500, though with considerable divergence across specific markets in the region. The German DAX, for example, has jumped more than 20 percent thus far in 2012, while Spanish equities have shed about 10 percent in U.S. dollar terms. The euro currency itself rallied against the dollar between July and September in response to the ECB, reversing an earlier dip and taking it back close to its end-2011 level. Equally importantly, capital flight from the peripheral countries appears to have slowed. Bank deposits have generally stabilized (Chart 2), and imbalances within the euro area’s internal payments settling system (TARGET2) have stopped worsening. Over time, these factors should help reduce bank lending rates facing corporations and households in peripheral countries, which have been slow to fall in response to ECB rate cuts. With a lag of a few months, these declining risk premia and borrowing rates should serve to lift euro area growth, in particular by lessening downward pressure on the peripheral economies.
Euro area peripheral bond spread and equities
Source: Bloomberg, JPMAM; data as of November 19, 2012 |
Peripheral country bank deposits (Jan 2009 = 100)
Source: European Central Bank, Bank of Greece; data as of September 2012 |
More recently, though, some of these gains have eroded. The OMT has not yet become operational, mostly because Spain — an obvious candidate for this type of assistance — has not requested help, presumably because of the political risk involved in accepting the associated conditionality. The ECB appears ready to implement the OMT, whose fate thus appears to depend largely on the Spanish government. More broadly, progress on the institutional front, including the drive to create a single banking system, has slowed. Spanish bond spreads, which narrowed by about 375bp between July and October, have widened about 85bp since. And euro area equities participated in the global sell-off, slipping nearly 6 percent from mid-October to the end of last week before bouncing alongside the U.S. market. Failure to turn the OMT from announcement to reality risks undermining its potential support to euro area growth and would likely require the ECB to create some other facility in an attempt to ease financial conditions in the periphery.
Nothing doing yet on the growth front. While our forecast includes improvement in euro area growth during 2013 — with GDP gains averaging just over 1 percent through the course of the year — no obvious sign of improvement has yet appeared. GDP contracted 0.2 percent Q/Q, SAAR in the third quarter, following a 0.7 percent dip in the second quarter of 2012. Neither did the monthly data flow improve during the course of the quarter. Perhaps more worrisome is that surveys are not showing any improvement in business or consumer confidence thus far, even though these indicators might be expected to reflect the improved financial environment quite quickly. To take two examples, both the overall EC Survey measure of economic sentiment and the Germany-specific IFO business survey continued to weaken through November, though the IFO’s expectations component did at least stabilize at a weak level (chart 3). For now, the euro area continues to struggle under the weight of ongoing fiscal austerity, an impaired financial system, and lower but still significant risk premia. With economic activity already at a weak level, the region is not experiencing a severe recession. But the roughly zero growth environment for now implies an ongoing increase in the euro area unemployment rate, weak corporate profit growth, and limited popular support for governments.