In the second quarter of 2010, the EU economy posted its strongest quarterly performance since late 2006. GDP growth accelerated from only 0.1% in Q1 to 1% quarter on quarter in Q2.
However, this better than expected gain obscures widely diverging growth patterns at the country level. While Germany's stunning quarter on quarter growth of 2.2% confirmed its status as the powerhouse of the EU, France, Sweden and the Netherlands made also robust gains. Much in contrast, the countries affected most by the public financial crisis continued to post a fairly weak economic performance: Spain and Portugal registered only 0.2% QoQ growth whereas in Greece GDP continued to contract sharply. Robust export activity remained the main engine of growth. It fuelled a solid rebound in industrial activity, particularly in the Eurozone as the weakened Euro enabled manufacturers to benefit from strengthening international trade.
Meanwhile, domestic demand remained relatively subdued in recent months although stock replenishment and public expenditure continued to have a positive impact on growth. The main exception is Germany where consumption and investment started to contribute more significantly to GDP.
Despite the dark clouds that were gathering over Europe due to the sovereign debt crisis casting gloom over economic prospects, confidence remained surprisingly strong and most indexes for consumer and industrial confidence as well as the general assessment of the business climate continued to trend up moderately further in recent months.
Manufacturing production has continued to increase by approximately 8% YoY in recent months. This robust growth figure hides markedly diverging trends amongst EU countries. On a par with the positive trend in the general economy, Germany's manufacturing sector is clearly in pole position, with an accelerating growth in output in Q2. In other countries, most notably Spain, activity remained lackluster.
Meanwhile, the rebound in the manufacturing sector has also broadened out, from initially only the automotive sector and its supplier networks to the electrical and mechanical engineering industry and the metal goods sector. Owing to the rapid economic growth in many emerging economies and supported by the continued weakness of the euro, EU 27 exports of machinery and vehicles grew in the 1st half of 2010 22% YoY, which resulted in the trade balance for those manufactured goods showing a healthy surplus of EUR 55 billion over this period.
Given the importance of the export-driven industrial recovery for the EU economy as a whole, the key question at this point in time is whether the rebound in the manufacturing sector will continue.
The global economy looks set to moderate to some extent in the remainder of 2010 following already a slowdown to more sustainable growth rates in the US and several emerging countries in Q2. Key factors leading to this slowdown are weaker support from the inventory cycle, government support measures gradually coming to and end and monetary policy tightening in the developing countries. This appears to have already had an impact on order intakes during summer. Industrial new orders in the EU 27 so far largely driven by export demand fell 2.3% MoM in July. Slowing global trade could have a dampening effect on dynamics in the manufacturing sector in the months ahead.
While export demand is expected to soften, there will be hardly any compensation from domestic demand at this stage of the recovery. Public spending still had a positive effect on domestic demand in Q2, but that support is likely to fade over the coming months and particularly in 2011 as government austerity measures will slow real GDP growth in the EU through rising tax pressure on companies and households and reduced government consumption.
The outlook for investment is nevertheless for a return to modest growth rates. Up to now, limited visibility on the business cycle has led to a cautious stance of the corporate sector towards capital investment. Reduced credit availability and higher cost of capital could have had also a negative impact on the corporate sectors propensity to invest. Moreover, lingering problems in the banking sector remain a key downside risk to the outlook for investment. The latest ECB surveys provide evidence of the financial sector tightening bank credit standards, reflecting increased concerns about banks' refinancing risks due to increased imbalances and sovereign debt levels across the EU.
On the positive side the gradually upward trend in capacity utilization across EU industry should be mentioned. The degree of capacity utilization is reported to be nearing a level (80%) which normally would trigger a rise in investment in machinery and equipment. Moreover, improving profits and companies so far shying away from increasing investment and hiring implies that the corporate sector is relatively cash rich. Hard data to confirm that the rebound of activity in the manufacturing sector looks set to have a sustainable character would be the right catalyst to shift investment into a higher gear.
Private consumers are facing other uncertainties. The most obvious one is the sluggish recovery of the EU labor market. First estimates for employment in Q2 signal a stabilization compared with the previous quarter. So far the manufacturing recovery has not generated news jobs and unemployment remained at 10% in July. Moreover, structural reforms are expected to result in a reduction of the number of jobs particularly in the public sector but will also affect employment in private companies. Uncertainty about job prospects will continue to act as a drag on private consumption as consumers saving more will limit spending.
Another uncertainty for households is the impact of the implementation of reductions in public spending and public sector salaries and rising taxes on disposable income. The euro continued to provide a boost to the export sector in recent months. However, having reached a record low of USD 1.19 in early June, the euro bounced back again to around USD 1.37 at the end of September on easing financial strains in Europe.
As far as the longer term outlook for the euro exchange rate versus the dollar is concerned, economic and monetary fundamentals still appear to justify a relatively soft euro. The implementation of austerity programs will act as a drag on domestic demand while little support from the European Central Bank is to be expected given the still benign inflationary pressures in the EU. In addition, the European banking sector is still not out of the woods as it is far from certain that banks will have enough capital to cope with new potential shocks.
In the near term, however, the expansionary monetary policy in the US suggests that the US dollar could lose further ground on the foreign exchange markets and particularly vis a vis the euro. This would imply that support from the euro to the competitive position of the Eurozone manufacturing sector in markets abroad could be fading with potential negative effects on exports.
As far as inflation is concerned, annual inflation was 2% in August, down from 2.1% in July. Monthly inflation amounted to 0.2% in August. The weaker euro resulted in particularly imported fuels for transport and heating and vegetables becoming more expensive. Inflationary pressures through imported inflation will continue to present upside risks for the inflation outlook. Meanwhile, weak labor market fundamentals and only moderate growth of economic activity present downside risks, which means that the risks regarding the inflation outlook are broadly balanced. This supports the view that at least until well into next year the ECB will maintain its current supportive monetary policy. The first interest rate increase is not expected before late 2011.
On balance, EU economic growth looks set to shift into a lower gear in the 2nd half of 2010 due to slowing global growth and consequently a moderation in international trade activity and growth in EU exports. Another reason for the slowdown is the likelihood that temporary factors supporting the stronger than expected performance of the EU economy especially in Q2 will fade over time. Annual GDP growth in 2010 has been revised upwards by 0.5 %-points to 1.9% compared to our June forecast. Particularly in 2011 austerity programs could have a dampening effect on GDP growth. However, despite continued high levels of uncertainty it is not expected that the EU economy will loose much of its current momentum. EUROFER's Economic Committee sees GDP growing by 1.8%, supported by a solid performance of the manufacturing sector, continued strength in export demand and a modest pick-up in domestic demand.