Two years ago, Mario Draghi pulled Europe back from the brink of disaster by promising to do “whatever it takes” to prevent a breakup of the euro. The single currency has survived, but the bloc’s economy is deteriorating once again. What’s more, fears are building that Europe lacks the consensus and the tools to pull out of the slump, and that in turn is sending financial markets around the world into a tailspin.
The recent slide in global stock prices turned into a rout on Wednesday, with major European indexes falling around 3 percent and the Standard & Poor’s 500 Index tumbling more than 3 percent at one stage before rallying late in the session. The yield on the U.S. Treasury’s benchmark ten-year note plunged an astonishing 33 basis points at one point — the biggest intraday move since the collapse of Lehman Brothers Holdings six years ago — and traded much of the day below 2 percent before recovering to stand at 2.13 percent late in the day, still the lowest level since June 2013.
Fresh U.S. data on Wednesday came in weaker than expected, with the government reporting small declines in U.S. producer prices (-0.1 percent) and retail sales (-0.3 percent) in September, but few analysts believe those numbers explain the severity of the market drop. Instead they say that rising concerns about Europe, which dominated conversations among financiers and policymakers at the annual International Monetary Fund–World Bank meetings in Washington last weekend, and falling oil prices were shaking confidence in the global recovery and triggering a big risk-off move by investors.
“Sentiment was very negative at the IMF meetings,” says Alberto Ades, head of emerging markets fixed-income and currency strategy at Bank of America Merrill Lynch in New York. “Everyone was positioned for higher Treasury yields. Nobody had Treasury yields going down.”
Germany underscored the gloom surrounding the European economy on Tuesday by cutting its forecast for growth to 1.2 percent this year and 1.3 percent next, down from 1.8 percent and 2 percent previously. A few days earlier the IMF had kicked off the annual meetings by downgrading its forecast for growth in the 18-nation euro area by 30 basis points this year, to just 0.8 percent, and by 20 basis points next year, to 1.3 percent. It also estimated that the risk of a euro area recession in the coming year had risen to nearly 40 percent, and the risk of deflation was nearly 30 percent (see also “Europe Remains the Weak Link in the Global Economy”).
Reza Moghadam, vice chairman of global capital markets at Morgan Stanley and former head of the IMF’s European Department, summed up the feeling of many. “Inflation is far too low and growth is even more disappointing,” he told a panel session at a gathering of the Institute of International Finance, held on the margins of the IMF meetings. “You are not seeing a pickup in demand or investment in Europe.”
Polled to identify the biggest threat to the global outlook, 46 percent of the crowd at the IIF meeting cited the risk of a European recession, compared with 23 percent who cited increasing geopolitical turmoil from Russia, 20 percent who pointed to a hard landing of the Chinese economy and 9 percent who identified volatility in the U.S. bond market.
Europe’s weakness elicited a dovish response from Stanley Fischer, the vice chairman of the Federal Reserve Board, who said in a speech at the IMF meetings that “if foreign growth is weaker than anticipated, the consequences for the U.S. economy could lead the Fed to remove accommodation more slowly than otherwise.” Market participants who two weeks ago were speculating that the Fed could begin hiking rates as early as April 2015 are now pushing back their forecasts to September and even November of next year.
Europe’s impact on the Fed and U.S. rates is overwhelming, contends David Rosenberg, chief economist and strategist at Canadian wealth management firm Gluskin Sheff + Associates. “No way are ten-year T-note yields at today’s level without German bund yields at 0.85 percent,” he wrote in a note to clients on Wednesday.
Calls for Europe to do something inevitably land in Germany, either on the doorstep of Chancellor Angela Merkel’s government in Berlin or at the ECB in Frankfurt. Last month Benoît Coeuré, a member of the ECB’s executive board, and Jörg Asmussen, the German Labor minister, called for Germany to use its budgetary leeway to stimulate investment and cut payroll taxes in an effort to spur growth.
IMF chief economist Olivier Blanchard urged the euro leaders to boost investment in infrastructure, saying it would spur their economies in the short run and raise potential growth rates over the long term. Larry Summers, the Harvard economist and former U.S. Treasury secretary, endorsed that idea.
“What’s happening in Europe is not working,” he said at a panel on Europe at the IMF meetings. “What followed in Japan was 15 years of deflation and dismal economic performance, followed by dramatic declines in interest rates. That is the path that Europe is on without a substantial discontinuity in policy.”
Notwithstanding the recent slowdown, however, German officials continue to reject calls for fiscal stimulus and says Berlin will stick with plans to balance its federal budget in 2015. “We’re not going to help the German economy with some flashes in the pan and more debt,” economics minister Sigmar Gabriel said Tuesday in releasing the government’s latest growth forecast.
Germany also continues to demand compliance with the European Union’s budget rules, setting up a potential clash with France later this month. EU governments submitted their proposed 2015 budgets to the European Commission on Wednesday, and the government of Prime Minister Manuel Valls is believed to have sent a plan envisaging a deficit of 4.3 percent of GDP, virtually unchanged from this year, and remaining above the EU’s 3 percent ceiling until 2017. Barring a sudden about-face in Berlin, the EC is duty-bound to reject the French budget and demand changes when it meets on October 29, raising political temperatures in Europe. That seems unlikely to boost confidence in France, which had its credit rating outlook lowered to negative by Standard & Poor’s last week.
The European Central Bank is due to release the results of its asset quality review and stress tests of major European banks on October 26, an event that officials hope will bolster confidence in the banking sector. “The uncertainty will be gone by the end of the month,” said Klaus Regling, head of the European Stability Mechanism, the EU facility created in 2012 to take charge of the bailouts of indebted member countries. “That could have a positive impact.”
Some bankers doubt that the ECB review will have a cathartic effect on their business and the wider economy, though. “Will it change overnight? I doubt it,” Erik Nielsen, chief economist at Italy’s UniCredit, told an IIF panel at the weekend. “There is virtually no demand for credit because companies don’t see demand for their products.”
For many analysts, Europe’s deepening funk and the lack of any political response means the ECB will ultimately be forced to embark on full-fledged quantitative easing and buy sovereign bonds. Yet few believe that such a move would change the outlook dramatically. As Moritz Kraemer, chief sovereign ratings officer at S&P, said in a presentation at the IMF meetings, “We think lasting growth will remain elusive.”
The big question facing global investors is whether Europe’s woes, and the resulting turmoil in global markets, will cause wider economic damage. Many economists remain relatively sanguine, at least for the moment. Economists at Barclays actually raised their forecast for third-quarter U.S. growth to an annual rate of 3 percent, up from 2.5 percent previously, because of strong business investment. Eric Chaney, chief economist at French insurer AXA, contended in a research note that recent payroll gains and strong corporate profits should sustain U.S. growth at a rate of 2.5 to 3 percent, and calls the sharp drop in Treasury yields an overreaction. But he noted that a sharp drop in German bond yields this summer presaged a subsequent deterioration in economic indicators there.
The markets seem to be of two minds, underscoring the growing anxiety. The U.S. stock market, even after its recent losses, is pricing in 3 percent U.S. economic growth, while the bond market is pricing in “a recession-like backdrop of 1 percent growth,” Gluskin Sheff’s Rosenberg wrote. “Both cannot be right.”
Follow Tom Buerkle on Twitter at @tombuerkle.
