Will Europe drag us all down?

While markets remain focused on the debt travails and bailouts of Europe, the underlying economy is in deep trouble. In fact, the Eurozone is plunging into recession – fast. Last night’s PMI was another shocker:

Conditions in the Eurozone manufacturing sector continued to weaken in October. At 47.1, down from 48.5 in September, the final Markit Eurozone Manufacturing PMI fell to its lowest level since July 2009 and below the flash estimate of 47.3. The PMI has remained below the neutral mark of 50.0 for three months. Signs of weakness are becoming increasingly apparent in the core nations, while the periphery remains mired in recession.

German manufacturing, one of the main drivers of the earlier Eurozone recovery, saw its PMI indicate contraction for the first time since September 2009. Rates of decline were the fastest for 27 months in both Austria and the Netherlands, while France signalled deterioration for the third month in a row. Rates of contraction accelerated sharply in Greece and Italy, with the performance of Italy deteriorating.

The drop is so fast that the final result undershot the flash PMI of a little over a week ago. The weakness is in both periphery and core countries:

New orders are also accelerating to the downside: Eurozone manufacturing output, new orders and new export orders all contracted at the fastest rates in almost two-and-a-half years during October…Ireland was the only nation to report expansions in output and new orders in October. Rates of contraction in production accelerated sharply in Greece and Italy, with the Italian output index suffering its sharpest month-on-month decline in the series history. France and Austria reported modest reductions in production, and slower rates of decline than in September. Marginal contractions were signalled in Germany (for the first time since June 2009) and the Netherlands.

We won’t know precisely how services are faring for two days but it’s certain to be much the same. Here’s how the services PMI looked last month:

So, the Eurozone is headed swiftly into recession. This is regardless of any further financial shock. To make matters worse, counter-cyclical policy is severely constrained. The debt wrangles of the European sovereigns means fiscal stimulus is dead (except perhaps for Germany?). Interest rates are already at 1.5% so cuts there offer limited scope as well.

Therefore, any rescue for the Eurozone is largely going to have to come from outside, that is external demand will need to offset internal weakness. Is that possible?

The EU27 constitute the largest economy in the world at over $16 trillion, roughly one quarter of global GDP (the Eurozone is roughly three quarters of this). The US, China and Japan are the three economies of sufficient scale to deliver a boost to Europe. The US’s slow recovery continues. But the Fed last night cut its growth forecasts for next year from 3.3% to 2.5%. There is no chance of fiscal stimulus there (with a growing chance of a repeat of August’s debt-ceiling debacle as the fiscal cuts Supercommittee is gridlocked). Inflation is slowly falling so the Fed could opt for QE3, which would reflate markets at least but not unless things get worse first.

As Michael Pettis explains today, Chinese credit appears suddenly very tight and he is looking for authorities to begin to ease in the near future. The ore market seems to have a sniff of that as well as it stabilises. There is some hope for a kick along for growth there. However, as I’ve said before, the Chinese authorities look determined to cap realty prices so easing will be paced with declines in that sector. Unless of course they get spooked.

That is quite possible. The two channels of transmission for European weakness are, as we know, a financial or trade shock. Let’s assume there is no further financial shock coming. But the trade shock remains very real. The typical business cycle ends when some kind of shock (usually monetary but this time fiscal) delivers a blow to demand. The result is that producers find themselves suddenly overstocked with inventory and they cancel orders. Businesses along the supply chain start to furlough or fire workers to maintain margins. This, in turn, delivers a further blow to demand and a negative feedback loop forms that leads to recession. This is called the inventory cycle.

The good news is that the EU has a less pronounced cycle than the US. Owing to its stronger trade union base and more collaborative relations between capital and labour (like Germany’s kurtzabeit system), the EU inventory cycle is less severe. Thus downturns tend to be less precipitous and upturns less spectacular.

But the cycle still exists and the EU economy imported $282 billion worth of stuff from China in 2010. It also had $170 billion in imports from the US and $65 billion from Japan (and remember Japan’s latest good trade data was largely driven by an unexpectedly high EU result). These are wide channels for economic contagion to spread into already weak or weakening other large economies. I expect all three to show negative impacts in their export sectors for the next few months at least. The danger is, if these trade drops are severe enough, that the US and China also start losing jobs, threatening their own inventory cycles.

So, even without a renewed financial shock, the world is facing a very nasty period ahead in which external demand is subdued at best and probably falling. That is already apparent in the global PMI for October:

Conditions in the global manufacturing sector remained broadly stagnant in October. Levels of production and new orders fell slightly over the month, while new export orders declined at the quickest pace for almost two-and-a-half years.

At 50.0 in October, little-changed from 49.8 in September, the JPMorgan Global Manufacturing PMI™ remained within 0.2 points of the no-change mark for the third month running.

So will Europe drag the world down further? At this stage I’d say there is hope that the little cycle of growth that’s underway between China and US can hold things up for a little while, but the exports of both are going to remain under sustained pressure, especially China. And with European activity likely to keep plunging (rescue or not) I’d say that unless there is some major new source of stimulus in the near term, the answer is yes.

Euro Zone