News & Analysis

Last week, the single currency breached its 33-month low against the US dollar due to weak economic data and coronavirus fears.

In the data, industrial production figures for December were especially disappointing. They came after January’s PMI surveys had suggested the slowdown in production had bottomed out.

Eurozone industrial production plummeted for the 14th month in a row in December, with the 4.1% YoY contraction marking the sharpest downturn in the sector since the financial crisis.

The euro proved highly sensitive to these releases, which is understandable considering the poor performance of the manufacturing sector in 2019 prompted fears of a recession. Output in the manufacturing sectors remains the weak point in the eurozone’s growth outlook.

Fears about the coronavirus outbreak’s economic impact added to the downside risks facing the domestic economy, fueling arguments for looser policy from the ECB.

Dovish expectations have arisen yet again despite ECB President Lagarde recently re-voicing her concerns about the negative side effects of prolonged monetary stimulus. Lagarde’s comments would normally have suggested that the central bank is searching for a path to normalization.

Investors have begun to mull the idea of further stimulus as per the worsening economic outlook and EU states resistance to increase fiscal support.

Although we believe the ECB is not yet on track for another policy move after the September stimulus package, hard macroeconomic data and forward-looking indicators that are released this week could prove pivotal in determining the ECB’s next move.

 

The Eurozone macroeconomic picture looks grim

Euro area GDP grew by 0.1% QoQ in Q4 2019, marking its slowest quarter for growth since 2013. The drag was mainly driven by contractions in the French and Italian economies along with economic stagnation in Germany.

Spain, on the other hand, was the lone economic outperformer among the four largest eurozone economies.

Overall, the latest GDP print implies annual growth of 1.2% in 2019, notably lower than the 1.9% in 2018 and below the average rate of growth over the last decade.

While the euro area economy remains underpinned by resilient domestic demand from the strongest labor market since the financial crisis, deteriorating external demand continues to drag on growth.

The global industrial slump on the back of heightened US-China trade tensions has only amplified the weaknesses in the eurozone economy due to its large exposure to global demand conditions.

While a similar divergence between services and manufacturing output in 2019 didn’t topple the eurozone economy, the widening spread between the two sectors suggests the bloc may enter negative growth in Q1 without a material improvement in manufacturing activity.

Coronavirus fears have largely erased any positive sentiment stemming from the January PMIs and the US-China trade deal.

Even though the eurozone has limited exposure to Chinese supply chains when compared to other countries, the potential damage of the outbreak on the eurozone economy is threefold.

  • First, the contraction in Chinese demand on the back of a slowing economy could trim eurozone exports in Q1 – China is the bloc’s third largest trading partner after the US and UK.
  • Second, among all European sectors, the automobile industry is one of the most exposed to Chinese inputs. The automobile sector is also highly sensitive to global demand conditions, with weaknesses in that industry spilling over in the bloc’s growth as a whole in 2019.
  • Finally, the impact on market sentiment on the already weak euro area economy could have ample consequences in investment, even if the shocks from China on demand and supply were to revert in the short-run. This is likely to concern the ECB who are already battling record low inflation expectations.
Chart: Falling German bond yields, a poor macro backdrop and political risks are dragging EURUSD down

 

Rumblings of Merkeldämmerung offer more uncertainty for Germany

Even under normal circumstances, the sudden resignation of a Christian Democratic Union party leader and presumptive heir to Angela Merkel would have caused a storm in German politics.

In light of the current malaise in the German economy, last week’s resignation by Annegret Kramp-Karrenbauer and the race to replace her takes on even more significance, both for the German economy and the eurozone as a whole.

AKK’s resignation was triggered by regional elections in the state of Thuringia, where the CDU voted with the far-right Alternative for Germany (AFD) party to install a state premier.

The range of possible outcomes in German politics is now very broad and uncertain and includes the possibility of resignation by Angela Merkel. This could lead to a collapse in the ruling coalition and a general election.

In the immediate future, the CDU must choose a party leader and a candidate for the Chancellorship. Options range from continuity candidates such as Armin Laschet, to potentially more conservative politicians such as Friedrich Merz.

The direction the CDU ultimately takes on issues such as European integration, the ECB, and fiscal policy could have a profound impact on the German economy.

 

Chart: Markets are beginning to expect policy action from the ECB

 

Even though no policy changes are likely in the coming weeks, any further developments in German politics will have the potential to have wider impacts in European markets.

 

Author: Olivia Alvarez Mendez, FX Market Analyst at Monex Canada. 

 

 

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