Yesterday’s release of second-quarter GDP data for the Eurozone indicates that the “increased softness in the Eurozone economies” we foresaw in our July 6 Commentary has been more severe than consensus expectations. The region’s economies GDP advanced only 0.2% in the second quarter, or +1.7% at an annual rate (y/y), down from +2.5% in the first quarter. Particularly concerning for markets was the 0.1% quarterly increase for the German economy, sharply lower than the 1.3% advance in the first quarter. The German economy, accounting for about 30% of the Eurozone economy, has been the locomotive for the region. Two other “core” Eurozone economies registered similarly lackluster performance: France, 0.0%, and Netherlands, +0.1%. Other Northern European economies fared better: Finland, +1.2%; Austria, +1%; and Belgium, +0.7%. Moreover, even Italy, +0.3%, and Spain, +0.2%, did a little better than the “core.”
European equity markets dropped at the release of these results, and global markets were also impacted. However, these are preliminary data and there are some reasons to think the subsequent revisions will be on the positive side, in particular for Germany. Industrial production in Germany registered a quarterly gain of 1.1% in Q2 and manufacturing orders advanced by 3.2%. We have not yet been given the details behind the GDP estimates. Perhaps stronger imports were a factor holding down the advance in GDP. In any event, attention is swinging back to the continuing sovereign debt problems in Europe, and further market volatility seems in store.
The meeting yesterday between the leaders of Germany and France, Angela Merkel and Nicolas Sarkozy, has disappointed anyone who expected major steps to be announced that would strengthen market confidence. They promised closer cooperation and integration, including the idea that debt limits be written into national law, and called for the establishment of a “euro-council.” Markets reacted negatively to several of their announcements. Merkel and Sarkozy indicated they will table again the financial transactions tax proposal only recently rejected. As anticipated, they made definitive statements that the idea of eurobonds, to be issued jointly by members of the Eurozone currency area, is not to be considered until the end of the process of integration of fiscal policies across the region. The UK, Italy, and even the opposition in Germany have suggested that issuing eurobonds could be a lower-cost approach to meeting the financial requirements of the debt crisis. Perhaps more disturbing was the assertion by Sarkozy that the present size of the European Financial Stability Facility (EFSF) is adequate. This will likely prove not to be the case. France and Germany will have to step up to the plate when the need arises, but until then they will say what their domestic public wishes to hear. Politics trumps financial-market concerns today.
Last week markets were roiled by concerns that the US downgrade by Standard & Poor’s would be followed by downgrades in Europe, in particular, for France’s sovereign debt. False rumors about French banks worsened the situation. Spreads on Spanish and Italian bonds had widened to a disturbing degree. The measures agreed by the European Summit on July 21st had yet to be drafted in a form ready for adoption by the member governments. The European Central Bank (ECB) stepped in and started buying Italian and Spanish government securities on August 8th. The ECB’s purchases last week are estimated to have amounted to 22 billion euros, which was sufficient to reduce the yields on these bonds by some 100 basis points. The ECB emphasized they took this step only after the Italian and Spanish governments had made significant progress in re-establishing fiscal discipline. A French downgrade proved not to be forthcoming, with the three rating agencies affirming the AAA rating. European markets recovered along with the global equity market snap-back.
Looking forward, our greatest concern with respect to Europe is the health of the Eurozone’s banking system and the broader economic effects of the vulnerable condition of European banks. The ECB Bank Lending Survey for the Eurozone shows their banks are tightening lending standards to enterprises. This will be a headwind for the Eurozone economies. Investors have driven down bank share prices, due in large part to concerns about possible future charges to capital from their exposures to peripheral Eurozone countries. France’s banks rank second to those of Ireland with respect to this exposure. French banks’ capitalization is less than the European average, and they are vulnerable to liquidity problems because of their heavy reliance on wholesale funding.
In sum, while the slowdown in the Eurozone economy may not be quite as severe as the preliminary GDP estimates for the second quarter suggest, momentum has definitely has been lost. The downside risks for the stalling economy are significant, with fiscal policies becoming more restrictive and credit conditions tightening. And without economic growth, it will be very difficult to realize needed progress on the fiscal front, despite the important steps governments have taken. At Cumberland, we are maintaining our underweight positions with respect to the Eurozone. Our International and Global Multi-Asset Class Portfolios are fully invested, with an emphasis on North American and Asian emerging market equity ETFs.
