What has happened?


Recent news flow for Europe confirms our opinion that growth perspectives are getting worse and political risks are rising. Today’s release of GDP numbers for Q4 2018 revealed that Germany has avoided a technical recession by the skin of its teeth in the end of last year. Yesterday Spain’s parliament has voted down the budget bill, most likely leading to a snap election. This adds up to a series of European concerns, including the sharp slowdown in German industrial activity, the US-EU trade conflict risks, Italy’s technical recession and the rising risk of a hard Brexit. Thus far, equity markets have been largely immune to these threats thanks to a friendlier outlook on some global issues such as U.S.-China trade talks and a more dovish stance by the U.S. Federal Reserve. Bond markets, on the contrary, seem to price in more sober expectations. For instance, 10-year Bund yields  are on a downward trend since October 2018, reaching their lowest level since late 2016 last Friday at 8 basis points.  The European woes threaten to cause even more headlines again soon, impacting both the economy and asset prices. Hence, we would like to give you a short assessment on the most crucial European issues at present.


Germany: Technical recession avoided but more weakness ahead


German growth in Q4 2018 stagnated 0% QoQ. Consensus expectations were set at 0.1% QoQ growth. After the growth number of -0.2% in Q3 2018, the German economy has narrowly avoided a technical recession, which is defined as two subsequent quarters of negative QoQ growth. Headlines about the German stagnation might impact consumer and business sentiment in the whole Eurozone. After all, Germany is not only Europe’s biggest economy, but has also been one of the most reliable European growth engines of recent years.


However, despite the stagnation in the last quarter, we think that Germany’s economy remains in rude health. While the requirements for a technical recession have almost been met, the definition of an economic recession in a broader sense doesn’t quite seem to be appropriate. The most widely accepted definition for an economic recession comes from the U.S. National Bureau of Economic Research (NBER): “A recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales”.


Against this background, German real income, employment, wholesale and retail sales all remain solid. Unemployment is on a post-reunification low, boasting 45 million people in employment as of December 2018 (an increase of +1.1% YoY), and real wages grew by 1.0% last year. Hence, domestic components should keep supporting growth, but growth drivers are changing as net exports are no longer supportive, in fact they subtracted 0.2 percentage points of growth last year. The dependency on exports has been the driving force behind the big shifts in the German economy. Since the beginning of the millennium, the net export surplus has started to grow almost every year. Net exports as a share of GDP were 6.9% in 2018, beyond the peak of 8% in 2015 but still higher than 2008. This dependency can be seen both as a blessing and as a curse. The industrial sector tends to be very sensitive to business cycle swings and, as a result, bigger changes in its output have been a good forecaster of economic turning points. While capacity utilization is above the long-term average, suggesting that the economy is expanding, it is decreasing, and indeed PMI manufacturing in January was in contraction territory at 49.7.


Next Thursday the February PMI will be published followed by the Ifo Index on Friday. As a result of the sharp downturn in the expectations component of the Ifo Index in January, the Ifo business cycle clock (a four quadrant presentation that plots expectations vs. the current business situation) has moved from boom to downswing territory for the first time in several years. Negative expectations are combined with a still solid but deteriorating business outlook. These forward-looking indicators may be influenced by political risks both in Europe and globally, as we discuss below.


Public finances remain in good shape, with a new record general government surplus of EUR 59.2bn, equaling 1.7% of GDP, the fifth surplus in a row. Such positive numbers should not be uncritically extrapolated, however. While the highly cyclical German economy could benefit nicely from fading tensions about international trade, the scaling back of previous reforms could become a drag on future growth as well as public finances in a more adverse economic environment. All in all, growth in Germany is slowing from a high level.


Spain: Snap election ahead


Yesterday, the budget bill of the centre-left Prime Minister Sanchez was voted down by the Spanish parliament after the government failed to secure the backing of the Catalan regional parties. Talks between the government and the Catalan regional parties broke down ahead of Tuesday’s start of the trial of Catalan independence leaders. Spain’s minority government may announce snap elections as early as today, with likely dates for the election being 14 or 28 April, 26 May and autumn 2019.


In current opinion polls, Sanchez’ Socialist party leads with 25% of the votes, followed by the centre-right People’s Party slightly above 20% and the centrist Ciudadanosjust below 20%. Left-wing Podemoscould get around 15%. The recent rise in regional elections (Andalucía) and in polls of the socially conservative party Vox(almost 10%) needs to be monitored as well.Compared to European peers, Spain’s economy seems more robust. GDP growth even accelerated in Q4 2018 thanks to strong household consumption. Furthermore, Spain seems less vulnerable to a manufacturing slowdown and U.S.-China trade tensions. The Spanish political landscape may remain fragmented, but the impact on the economy will likely be limited in our view. With regards to the new election, an alliance led by PP-Ciudadanoswould be mildly positive for the Spanish economy as the risk of big social giveaways -such as the 22.3% hike in the minimum wage introduced by PM Sanchez - that threaten public finances and therefore constrain Spain’s long-term growth potential would be reduced. Nevertheless, parties advocating growth-inhibiting measures will probably struggle as much as those that call for further pro-growth reforms. Following the strong reform drive in the years after the euro crisis, political gridlock or weak governments that struggle to push through major changes may not be too bad after all given the experience in the last few years. Beyond the rise in the minimum wage, which will likely slow the pace of job creation in services and lead to more temporary instead of permanent work contracts, we do not expect major reform reversals under any of the realistic political scenarios. Hence, potential setbacks in risky assets and a widening of Spanish government bond spreads due to higher political risks could be regarded as an interesting opportunity for Spanish assets.


Italy: On the brink again


Italy has entered a technical recession at the end of last year, and leading indicators thus far are not pointing to a strong rebound anytime soon. The slowdown was more pronounced than elsewhere in Europe. Softer business investment and household spending amidst domestic political uncertainty and higher financing costs seems to be the main driver behind this economic weakness. The agreement reached between the Italian government and the European Commission over the Italian budget last December might be challenged again. GDP for 2019 is likely to be softer than the government’s budget assumption (GDP growth of 1%), which would increase the budget deficit above the targeted 2.04% of GDP. Hence, Italian’s public finances are likely to remain a burden for capital markets. Steps towards a budget consolidation and restoring investor confidence are still missing.


Last year’s confrontation with the EU led to a widening in risk spreads, which in the end pushed Italy into a technical recession. A potential renewed conflict with the EU might damage the Italian economic outlook further. Nevertheless, Euro-sceptic Lega lawmaker Claudio Borghi has started a discussion about putting the central bank’s substantial gold reserves (2452 tons) under direct government control and potentially sell some of them to fill gaping holes in the budget. Separately, the Italian vice-presidents Luigi Di Maio (5Stars) and Matteo Salvini (Lega) have blamed the Banca d’Italia for failing to supervise banks properly, thus causing recent banking crises. Di Maio and Salvini want to change the leadership teams of the relevant institutions whenever the terms of the current members are up. The gold initiative will likely disappear in the near future, as have similar initiatives in Italy (and even in Germany after re-unification) in previous decades. The Banca d’Italia is not in charge of banking supervision, but the Italian government seems to be trying to shift the blame for Italy’s current banking woes away from itself. The net effect is an increased Italian risk spread and further damage to Italy’s growth prospects.


However, we think that other fundamentals (robust current account surplus, interest payments on public debt of just 2.6% of GDP) are solid, and expect Italy to muddle through for a few years without a genuine debt crisis. But an unexpectedly harsh recession in 2019 or major government mistakes could raise the risk. Long-term, Italy will either have to return to a pro-reform government or face the risk of a severe public debt crisis. Hence, it is advisable to remain cautious on most Italian assets. 


Brexit: Running down the clock?


Although the clock is ticking, the UK parliament has so far failed to move the UK away from the a hard Brexit. The parliament is still badly divided over Brexit as was demonstrated in the last weeks over various amendment votes on PM May’s  Withdrawal Deal (WA), to be continued this week. The ongoing political paralysis raises the likelihood that the UK could leave the EU without a deal.


On the contentious issue of the backstop guarantee against a hard border in Ireland, the EU is unlikely to give in, even if PM May tries to rise the pressure in upcoming talks. The EU may offer further re-assurances that it does not want to use the backstop. But it would only drop the backstop if the Republic of Ireland were to say that a hard Brexit would be worse than a Brexit deal without a backstop. So far, we see no sign that Dublin, and hence the EU, will blink in what seems to be descending into a game of chicken between the UK and the EU. As a result, parliament is likely to vote down May’s deal again when it comes to the next “meaningful vote” – now scheduled for February 27 after a parliamentary session in two weeks’ time, where further amendments to the WA may come up for discussion once again.


Although there is a narrow majority in parliament (318 to 310) against a hard Brexit, as a symbolic vote on such an outcome demonstrated last week, this alone is not enough to prevent such an outcome. A hard Brexit is the default option unless a deal or delay is secured before Brexit day on 29 March 2019. With less than 45 days left until the UK is due to leave the EU, we still see the likelihood of a no-deal at 35%, and the chances for other outcomes  (“Norway plus smooth – soft Brexit” and “no Brexit”).


Possibly, the sheer time pressure leading up to March 29 could focus parliamentarians’ minds in the coming weeks. After failing last week to grasp an opportunity to steer Brexit, we expect the majority of MPs that favour close ties with the EU to have second thoughts when it comes to the next vote on May’s deal. That will provide another opportunity for parliament to influence the outcome of Brexit. After that, the next approaching hard time line would be the EU summit on March 21 before the deadline March 29 one week later. Because time is running out, any “deal” outcome will probably need an extension to Article 50 – by a few weeks – to give the UK the necessary time to ratify whatever version of the WA and future partnership. In case the UK decided to go for a second referendum, or even a general election, an extension lasting several months would be needed. In any of these scenarios, we would expect the EU to agree to the necessary extension, including any accommodations needed for the 23 – 26 May European elections. In our view, however, the EU is unlikely to agree to a lengthy extension for the purpose of simply giving the UK parliament more time to make up its mind. Stay tuned!


Trade war risks: U.S. to take on the EU shortly?


The ongoing negotiations between the U.S. and China support the hope that the two sides can agree on enough substance shortly to avert the envisaged rise in U.S. tariffs on $200bn of U.S. imports from China from 10% to 25% on 1 March. Unfortunately, that in itself would not end the trade dispute. The separate U.S.-EU trade agreement, which U.S. President Donald Trump and European Commission President Jean-Claude Juncker struck on 25 July 2018, may soon be in danger. On May 23 of 2018, U.S. President Donald Trump instructed the Department of Commerce to investigate whether car and car part imports “threaten or impair the national security” of the U.S. The report is due within 270 days, that is no later than 17 February 2019. Trump would then have 90 days to decide whether he wants to levy punitive tariffs on car imports. Although the recent U.S. government shutdown may still cause a delay, it seems likely that the U.S. will soon increase the pressure on the EU with a threat of 25% car import tariffs to come.


Unlike the U.S.-Chinese issues, the U.S.-EU talks are not influenced by a geostrategic rivalry. In fact, in the U.S., political support for a trade war against the EU seems to be much weaker than for one with China. Still, the talks might not be easy. The EU wants to strike tariff-cutting deals on industrial goods (“we abolish our car tariffs, you abolish your SUV tariffs.”). However, the U.S. is also seeking enhanced access to the EU agricultural market. On this issue, the political room for the EU to yield to U.S. demands is very limited – in particular in France.


The exchange of goods and services between the U.S. and the EU is the biggest bilateral trade flow in the world, ahead of U.S.-China trade, with U.S. exports to and imports from the EU estimated at $570bn and $670bn, respectively, in 2018. In commercial terms, the EU could hit back at the U.S. much harder than China could. The EU has already shown that it has a good idea which sectors may be politically sensitive in the U.S. in the run-up to the 2020 election season. As both sides have too much to lose from an escalating conflict, we expect the U.S. and the EU to defuse tensions in the end. But only time will tell.


Our view


The Eurozone economy has slowed down and risks are tilted to the downside. Some of the slowdown at the end of last year was caused by temporary supply-side factors which should at least partially recover.  While the difficult external environment is a challenge for the export-orientated Eurozone economies, many problems are self-inflicted. Political uncertainty might derail business investment and household consumption, which is particularly painful in times of softer external demand. Additionally, the room for fiscal support is limited in many European countries due to excessive public debt. All in all, we do not foresee a broad-based European recession in 2019, but the growth slowdown might be more pronounced than initially anticipated. With regard to the investment outlook, we would like to reiterate some of our 2019 outlook themes: expect slower macro and corporate earnings growth, be vigilant on volatility and prefer U.S. over European equities.


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