Eurozone engine stalls

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With both Germany and the rest of Europe registering almost zero growth last quarter, traders’ and investors’ growth concerns were reawakened yesterday, which for a time weighed on stocks, oil and the euro, and benefitted safe-havens such as treasuries, gold and the Swiss franc. At one stage, the DAX was down almost 3%, the gold price traded above $1,790, the Swissie fell back under 0.78, and the 10-yr Bund yield was down by 5bp. However, some better-than-expected industrial production data out of the US and Fitch’s affirmation of America’s AAA-rating steadied earlier nerves.

In response, risk appetite gradually returned, with the DAX ending down just 0.5%, the Swissie climbing back above 0.80, and the Aussie threatening 1.05 once more. It is worth observing that had this negative growth news out of Europe emerged either last week or the week before, the market response would likely have been much more adverse. How much can be read into this price action remains to be seen. It might only be the calm before the next storm.

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Commentary

High inflation helps the pound. The latest inflation data in the UK is part of a now familiar pattern, with headline inflation coming in higher than expectations. The 4.4% outturn for July comes after the 4.2% reading in June and the details show fairly broad-based price increases when looking at the contributions to the move higher in the headline rate. The biggest factor is the miscellaneous goods and services category, being pushed up by higher fees for financial services. Seven of the 12 categories were pushing the headline rate higher, with only two delivering an offsetting downward force. Furthermore, increases in household utility bills are on the way and these are likely to push the headline rate above the 5.0% level in the coming months. The Governor of the Bank of England, who is now well-used to letter writing, again underlined in his letter to the Chancellor that, if it were not for factors such as rising VAT, energy and import prices, inflation would be below 2%. The rest of the letter not surprisingly differs little from the message in the August inflation report, namely that inflation is likely to move to 5% and move back below 2% thereafter, but it all remains highly uncertain. Sterling has so far taken the data in its stride and there’s no doubt that it has gained some support from the storms elsewhere over the past couple of months. But looking forward, the key question is how an increased debate regarding the prospect of further QE will sit at the same time headline inflation is moving above and beyond 5.0%. The market would have to place an ever-greater reliance on the bank’s long-held assumption that inflation will fall back to target and this could prove a heavy burden for the currency.

Stall at the core of the eurozone. The preliminary German numbers revealed that the economy grew a mere 0.1% QoQ in Q2, this coming on the back of the flat outturn in France. There was also a modest downward revision to the 1.5% Q1 outcome for Germany, down to 1.3%. Clearly, the timing of this slowdown is pertinent, given that Merkel and Sarkozy met yesterday in Paris to discuss developments in the sovereign crisis. The triple-A rating of these nations is key to ensuring that the EFSF is able itself to be triple-A rated and thus offer funding at low rates of interest on loans to the periphery. This is not to say that this rating is under threat, but the issue is that there is an ever greater burden – doing the heavy lifting through the crisis – being placed on France and Germany. If the fuel to achieve this starts to run dry, then investors will rightly be worried that the foundations of the current eurozone rescue structures will start to collapse. Neither France nor Germany have reached their pre-credit crisis peak in terms of output, with the same now holding true for the US after its latest GDP revisions. This illustrates both the sluggish nature of the recoveries seen on both sides of the Atlantic, as well as the depth of the drop in output. But it also means that there is less economy available to tax, at a time when liabilities keep on rising due to an ageing population. The pressure for more fiscal stimulus is mounting once again in certain economies, but the issue of affordability is now far starker than was the case three years ago.

Norway suffers much like the Swiss. Much attention in currency markets recently has focused on the potential damage which the incredibly strong exchange rate might wreak upon the Swiss economy in coming quarters. Over recent days, there has even been speculation that some form of currency peg to the euro is under serious consideration, although this seems both premature and unlikely. Somewhat forgotten in this discussion is that Norway is having to deal with a similar issue, with the krone also benefitting from considerable safe-haven flow over recent weeks and months. For the year-to-date, the Norwegian currency has climbed more than 8% against the dollar, and recently attained a four-year high against the single currency. In part, the krone’s gains reflect the favourable impact of much higher oil prices, which in turn provides the government with enormous revenue. Indeed, one of the considerable attractions of the krone for foreign investors is the fabulous state of the public finances – in 2010 Norway had a budget surplus of more than 10% of GDP, the largest of any of the top-rated sovereigns. In addition, the Norwegian economy continues to record decent growth, and boasts one of the lowest unemployment rates in Europe. Of concern for Norway is that the high exchange rate and rising wage demands are beginning to weigh on the competitiveness of the trade sector. Recently, the central bank has been reluctant to raise rates any further, conscious that the global outlook is looking less assured. Policy calibration in Norway is becoming increasingly complex these days.

China still using yuan appreciation to combat inflation. That constant wailing from Washington berating China for failing to allow its exchange rate to appreciate sufficiently quickly is less prevalent these days. Policy-makers in China recognise that an appreciating exchange rate can play a critical role in moderating the incipient inflationary pressures that currently represent the country’s major policy challenge. The yuan continued to advance yesterday, registering a new 17-yr high of 6.3925. Already this month, the yuan has risen by 0.8% against the dollar. Separately, an editorial in the influential China Securities Journal claimed that it would be appropriate for the yuan’s trading range to be widened as a way of reigning in one-way speculation that the currency will appreciate. The current daily trading band is 0.5%.


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