European Economic Outlook: Back In Recession

High frequency indicators in the past month continue to depict Europe's darkening economic landscape. The composite Purchasing Managers Index (PMI) for the eurozone, an indicator of manufacturing trends, fell to 47.2 points in October from 49.9 points a month earlier, the biggest drop since July 2009. At the same time, new orders in eurozone manufacturing fell for the third month in a row, while export orders lost ground for the fifth consecutive month. The contraction in activity has also spread to services, with the eurozone services PMI in October at its lowest since July 2009.

In Standard & Poor's view, Europe's approaching recession first took hold in Spain, Portugal, and Greece, and the economic woes are now spilling over into the eurozone's core of France and Germany. The composite PMI for France and Germany dipped below the 50-point mark in October--a signal of recession--continuing the downtrend it started in September. Also, in October Italy's composite PMI recorded its sharpest monthly decline since 2009.

In revising our forecasts for 2012 and taking a first look at 2013, we have once again cut our 2012 real GDP growth forecasts for France to 0.5% from 0.8%, Germany to 0.6% from 1%, and Italy to 0.1% from 0.2%. We now expect a mild recession in first-half 2012 in the eurozone, ahead of a modest pick up in the second part of the year. We anticipate eurozone real GDP growth to average 0.4% next year (see table 1 at the end of this article).

Turmoil In Financial Markets Is Adding To The Gloom

Monetary conditions are still supportive, based on current levels of short-term interest rates. The European Central Bank (ECB) cut its policy rate by 25 basis points (bps) on Nov. 2, 2011, to 1.25% and we expect it will cut rates again in December or in January. Meanwhile, the Bank of England's Monetary Policy Committee has reiterated that its policy rate would remain on hold at 0.5% for the foreseeable future. However, transmission to the real economy remains problematic, in our view. Loans to non-financial corporations in the eurozone inched up a meager 1.3% in the 12 months to September. Loans to households advanced 3.2% over the same period, but housing loans in specific countries, such as France, inflated this slightly stronger growth.

At the same time, the latest ECB survey of loan officers showed that banks are tightening their credit standards. Financial institutions are having a tough time accessing funding, and their stock market losses over the summer have prompted many to deleverage and speed up the restructuring of their balance sheets. We anticipate that credit conditions will worsen in the coming quarters, accentuating recessionary pressures.

Trade Performance Is Key

Financial markets have increasingly focused their attention on trends in each European country's current accounts since 2008. This is because current accounts provide a meaningful indicator of a country's dependency on the rest of the world to finance its economic growth. Permanent current account deficits imply ever growing indebtedness.

But it is worth stressing that a country's current account position (surplus or deficit) depends essentially on its trade performance. This is because a surplus in services (tourism, other exportable services) is hardly ever sufficient to offset a deficit in foreign trade of goods. Even for Europe's best performer, Germany, exports of services only amount to 20% of exports of goods.

A look at France's current accounts shows they moved from surplus in the early part of the previous decade to deficit in 2005, virtually in sync with the deterioration in the French trade balance in the past six years. Similarly, we observe that Italy's current accounts and trade balance have both deteriorated steadily in parallel since 2003.

Chart 1

By contrast, Spain's current accounts have started to improve since 2007, mirroring a reduction in the country's trade deficit (see chart 2). In other words, foreign trade performance remains essential for the success of a country's overall debt reduction.

Chart 2

Export Performances Vary Widely Across Countries

To assess how some eurozone countries have been faring in terms of trade performance since 2000, we have compared their exports of goods with those of Germany's. The ratios of France and Italy have, over time, declined against German exports (see chart 3). French exports equaled 55% of German exports at the beginning of the century, but then dropped to 40% by year-end 2011. We note, however, that this ratio stabilized to a degree during the 2009 recession. This is because French exports are less exposed than Germany's to non-European markets, where the downturn was particularly severe. However, since the beginning of 2010 the downward trend seems to have resumed. The decline in the ratio for Italy is equally pronounced. Italian exports had fallen to 35% of German exports at midyear 2011, versus about 45% of German exports in 2000. Correcting these imbalances will require proactive, long-term economic policies, in our opinion for both France and Italy.

Chart 3

We didn't calculate the same ratio for U.K. exports in chart 3, because the sharp depreciation of the pound against the euro since 2007 artificially reduces the ratio when U.K. export figures are converted into euros. In fact, U.K. exports have benefited greatly from the pound devaluation since 2007. Between September 2007 and September 2011, U.K. exports of goods grew a cumulative 33%, compared with Germany's 10% advance in the same period. By contrast, between 2003 and 2007, U.K. exports rose only 14%, versus 39% for Germany.

For a comparison of Spain's, Portugal's, and Ireland's export performance relative to Germany see chart 4. Spain's exports have remained remarkably stable when measured against German exports of goods. This means that as domestic demand for foreign products contracted, the subsequent reduction in imports of goods has fueled a progressive rebalancing of Spain's current accounts and trade balance since 2007. In other words, rather than a marked counterperformance in its exports to foreign markets, excessive domestic demand has prompted Spain's external imbalance to a large degree. This is also true for Portugal, where exports have remained very stable when compared with Germany's.

Ireland's performance falls in the middle. In the first part of the previous decade, we see the decline in Irish exports as correlated to the booming domestic economy, and a trade off between export growth and domestic demand prospects. Since 2008, Irish exports have stabilized as domestic demand contracted.

Chart 4

Another Recession Draws Nearer In Europe

With world trade growth poised to slow in 2012, in our opinion Europe's economic outlook once again appears increasingly somber. The necessary reductions in most European countries' overall indebtedness, via improvements in their current accounts, will in our view be all the more difficult to achieve. We believe that those countries where exports of goods have posted significant counterperformances in the past 10 years--namely France and Italy--face a particularly challenging task ahead.

Table 1