Could the Eurozone rebound be stronger than expected?

By Richard Kelly, Senior Economist, TD Bank Financial Group

Tourists and locals stroll along a street in Venice, Italy.

The Eurozone may be on the verge of a significant economic rebound.

As the global economic recovery began to take shape, the general consensus was that the Eurozone would lag behind. Our own forecasts anticipated a tepid recovery in the Eurozone in 2010, as well. Were these forecasts shortsighted?

Early outlook bleak

The fact that the European Central Bank (ECB) was less forthcoming in monetary stimulus than other central banks helped fuel the gloomy forecasts. As well, Eurozone governments provided smaller and less coordinated fiscal stimulus packages than those of the U.S., for example. Eurozone banks, which had lent heavily to Eastern Europe, would see their struggles tied to the economic prospects of Eastern European economies. Lurking behind these factors was the knowledge that the European labour market typically takes longer to adjust following a recession.

Gradual turnaround

In many regards, however, we have seen these risks pared back over the last few months. So much so, that in our June Quarterly Economic Forecast, we upgraded our forecast for the Eurozone economy to a 1.2% annualized growth rate in 2010, more than double the current consensus.

Risks from Eastern Europe were reduced with a large share of debt reportedly renegotiated and successfully rolled over. The ECB, absolutely slow to respond to the downturn, did eventually catch up in providing stimulus. In late June, the ECB effectively provided EUR442bn in one-year loans to more than 1,000 banks at just 1.00%. A large share was then re-deposited and held in cash, but that does provide much-needed liquidity to the system.

Rebound versus recovery

With evidence coming from the Eurozone economic sentiment indicator, we think it is now appropriate to ask whether the Eurozone is on the verge of a significant rebound. However, it is important not to mistake “rebound” for recovery. The recovery will be a long process to bring manufacturing levels back to pre-recession levels, to rehire laid-off workers and to eventually restart capital investment. The rebound will be a short-term bump coming in the Q3/Q4 period and will likely be largely driven by the inventory cycle.

As occurred globally, the steep decline in the Eurozone’s economic activity was exacerbated by the tremendous uncertainties over what the future would bring. Businesses scaled back more than they typically would, and inventories in many cases were cut to almost nothing. And yet, the worst case was avoided for the Eurozone and global economy. As a result, positive sentiment seems to be returning to businesses, and with low inventories, some production will be needed.

So how big could this rebound be? The correlation between economic sentiment and industrial production shows that industrial production (measured on a three-month percentage change basis) could possibly recover to its strongest pace since the data began in 1990. It will be important to track this trend over the next couple of months of data to determine whether it continues, but this could translate into GDP growth of a 4% to 5% annualized rate in the third or fourth quarter of 2009. This would then set up the economy for an expansion much closer to the 1.2% pace we are forecasting for 2010, rather the consensus view for less than half a percentage point or less.

How will the ECB react?

A significant rebound would also indicate that further stimulus from the ECB is unlikely. In fact, industrial production of this magnitude would typically be associated with higher interest rates, not lower. We anticipate the ECB will look through this initial rebound, and to the size of the trend recovery in 2010, before raising rates.

On the other hand, the ECB is arguably the most uncomfortable of the major central banks with having the level of the policy rate at an all-time low. So there is also the prospect that the ECB could begin to raise rates as early as the first quarter of 2010, depending on how resilient the recovery remains at the end of this year. We would also look to the monthly Monetary Financial Institution (MFI) bank lending data, which has been a good indicator of ECB actions.

Whatever direction the ECB takes, the level of interest rates will still be conducive to Eurozone economic growth. In the new paradigm for central bank actions, there has been some approval of the idea from ECB officials that interest rates can and should be used as a means of avoiding financial bubbles. So, interest rates may move higher in 2010 rather than later.

Highlights

Recent economic indicators suggest the Eurozone could see a very powerful rebound at the end of this year.
This rebound could result in real GDP growth hitting a 4% to 5% annualized rate in the third or fourth quarter.
The full recovery will still take time, but consensus forecasts seem to be lagging the full scope for economic growth in 2010.
We believe the ECB is now firmly on hold, and in fact could be driven to hike rates very gradually beginning in the first half of next year.