Is optimism in Euroland justified?

At the Room 151 get together for local government treasurers last week, one of the topics discussed was the outlook for Euroland, and despite enthusiasm for many commentators, there is clear weakness in household real income growth and signs that the credit crunch within the banking sector has intensified in recent months, as banks have sought to de-leverage and repay or replace ECB credit lines.

The optimism expressed by many commentators is a reflection of the buoyant private sector confidence indices but we can worry that such measures may be distorted by seasonal adjustments and enthusiasm based on equity market pricing rather than hard fundamentals as well as an element of hope, in that most of the ‘better’ numbers relate to future expectations rather than current conditions.

In terms of the most recent direction of travel of the data, there does seem to be a hint of improvement in parts of the Periphery but not within the Core, and what improvement there is seems to be primarily in demand, with the example Italian retail sales growth less negative. There are plenty of suggestions as to why the data seems to be better, but scant hard evidence or consistency as yet. There are tentative signs that new businesses are hiring new workers in some areas of the periphery on the back of lower labour costs and Eurostat data suggest that unit labour costs have fallen sharply. But much of the fall in reported average unit labour costs in the Periphery over recent years can be seen to be the result of survivorship bias in the data, with employment in the unproductive construction sectors falling away, and therefore average productivity in the economy rising mathematically rather than because real productivity has risen. Importantly within the traded goods sectors of these economies, there is little evidence that unit labour costs have fallen. Thus in Italy, the official data show industrial wages up by almost 2% over the last year while implied productivity has declined, suggesting that unit labour costs in the traded goods sectors may have risen, with further net divergence from the benchmark of Germany’s unit labour costs. There does seem to have been some progress in Spain, with average industrial sector wages up by 1% both last year and the year before, and implied productivity growth of around 2% per annum in recent years. But whilst the implied unit labour cost position of Spanish industry seems to have improved by around 6% relative to Germany in the last few years, is insufficient to solve the pre-existing cost differential between the two economies. For sure Spain’s net export receipts have been improving, but the primary cause of the improvement in the trade balance looks to have been weakness in import demand, reflecting weakness of the domestic economy.

As for fiscal balances, in Italy, and to some extent in Spain, it seems that governments’ budget deficit positions have been widening again, with Italy moving towards an overtly more expansionary fiscal stance while Spain’s drive to reduce its budget deficit has seemingly ended. These shifts in stance will also have supported demand trends, and may reverse, but markets have been giving the benefit of the doubt absent evidence of any improvement in the fundamental trading and competitiveness positions of economies – whilst the key risk is that easier fiscal policy and a fixed expensive currency may result in weak local debt markets and the real wage adjustments, as seen in 2011-12. As a connected issue, Europe’s commercial banks may elect not to fund expanding deficits, forcing the ECB to fund or to face another sovereign debt crisis. Portugal has already been told to re-tighten fiscal policy but it’s not easy to see how electorates would respond to any return to austerity in Italy and Spain, so a sort of standoff between peripheral economy governments and the ECB may result. The ECB could monetise budget deficits of peripheral economies by direct purchase of sovereign bonds, but it’s hard to see that the legal steps required to facilitate this, will be taken in the near term. This leaves the principal options open to the ECB as another LTRO to encourage commercial banks to help out, or setting negative interest rates on bank reserves thereby forcing banks into the debt markets. The practical challenges of imposing negative nominal interest rates are significant so the ECB would likely prefer another LTRO – but if that were to be implemented, markets may move to punish lax economies and their markets. For now peripheral economies and markets are higher risk.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla