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Sunday, May 24, 2009

Europe’s Economic Activity Looks Up (a bit) In May

Well the eurozone outlook is certainly deteriorating less rapidly at this point than it was, at least this is the impression given by the May flash Purchasing Managers Indexes (PMIs) - which show the pace of economic contraction slowing markedly from April. PMI readings for the 16-country euro area rose significantly this month, and hit their highest level for the last eight. It is, however, important to bear in mind that the index still registered contracting economic activity, even if the rate of decline fell for a third consecutive month. Chris Williamson, chief economist at Markit, who compile the indexes, said the latest readings were consistent with second quarter GDP falling about 0.5 per cent quarter on quarter (or by a 2% annual rate), well down from the 2.5% quarter on quarter GDP outcome (or 10% annual rate) in the first three months of the year. That being said, we are still in the realm of contraction, and organisations such as the International Monetary Fund, the European Commission and European Central Bank continue forecast a return to positive growth only in 2010.

In fact, May’s eurozone “composite” index, covering manufacturing and services, stood at 43.9 in May, up from 41.1 in April, the highest since September.

The eurozone economies, especially the export-led German one, showed themselves to be particularly vulnerable to the collapse in global demand after the failure of the Lehman Brothers investment bank. Most hopes for short term recovery are based on the idea that since companies have now substantially reduced inventories they will need to step up production to meet future orders. And this, it is true, will give a short-term uplift to output (which is what we are seeing). But for this short term uplift to translate into a full-blown expansion, the demand for inventory renewal has to provoke an increase in investment to fuel an anticipated future increase in demand, and it is far from clear that we are seeing this at this stage.

We do not have detailed data for Q1 GDP for the eurozone economies yet, so evidence for investment behaviour is scanty, but if we look at the evidence from Japan, investment activity slumped massively in between January and March, and there is no reason why the situation should be very different in Europe. Japanese business investment was down a record 10.4 percent year on year in the first three months, and a massive 35.5% over the last quarter.

On the other hand, eurozone economic activity will continue to come under pressure in the months to come as the impact of the sharp contraction in activity feeds through into the labour market. And companies are likely to keep cutting spending because the decline in external demand has left factories operating well below capacity level, and semi-idle workforces can only be retained for so long. Markit said that the pace of job losses had eased this month – but only slightly compared with the record pace reported in April.

The flash reading only gives details for two of the euro area's big four. The rate of decline in Germany's private sector eased to its slowest in seven months in May, and the composite index rose to 44.4 from 40.1 in April, suggesting the contraction in the second quarter will be much slower than the 3.8% slump (15.2% annualised) in the first. Markit estimated that we may be looking at something like a 0.6 decline (-2.4% annualised). The outcome may be a bit worse than this, but still a significant improvement seem certain.

The German manufacturing PMI index rose to 39.1 from 35.4 in April, while the services sector index rose to 46.0 from 43.8. The manufacturing index was dragged down by major job losses in the sector, and according to Markit "Manufacturing employment in Germany is falling at a far, far faster rate still than services...Manufacturing has really been hammered even though there was some easing in the rate of job losses in May."

The French services PMI was up at 47.6 in May from 46.5 in April, while the manufacturing sector also rose to an above expected level of 43.1 from 40.1.

So it would be very premature to draw the conclusion that we are out of the woods yet. The euro hit 1:40 to the dollar on Friday, and with this level it is hard to see how German exports are going to stage a recovery with currencies like the Swedish Krona and the UK pound down something like 20% over the last year. And remember, with Italy and Spain themselves in deep recessions German companies are now going to have to look well beyond the eurozone to find those much needed customers.

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