An image of the planned new headquarters of the European Central Bank in Frankfurt. The construction is expected to be completed by 2011.

The Eurozone economy is forecast to contract -3.7% in 2009 and GDP (gross domestic product) is expected to rise 1.2% in 2010 according to US investment bank Morgan Stanley.

MS economists Elga Bartsch and Daniele Antonucci, based in London say in their latest forecast that to their surprise, the indicators hinted at some major upside risks to near-term GDP estimates. Aggregating the country models suggests that, for the Eurozone as a whole, GDP could have expanded by as much as 0.9% (or 3.6% SAAR - -seasonally adjusted annual rate) between July and September.  This compares to its cautious forecast of 0.2% previously.  In terms of the countries, the main upside surprises emerged in Italy (where industrial production surged a substantial monthly rise of 7% in August) and France. Meanwhile, there were only small discrepancies relative to the official forecasts in Germany and Spain. 

The latest forecast compares with a -4% in 2009 and 0.8% in 2010 - -  a cumulative change of 0.7%.

MS says importantly, the forecast upgrade does not change their fundamental assessment that the deepest recession in post-war history in the Eurozone will be followed by lacklustre recovery.  This is by no means a V-shaped recovery. Even with such a smart rebound during Q3, GDP would still be 4.3% below its early 2008 peak.  In the MS view, a sustainable recovery in domestic demand is still far off, as capacity utilisation rates are still near rock-bottom and unemployment is set to rise further. The economists say as the upside near-term surprise is due to a turnaround in the inventory cycle, it is also likely to be short-lived.

They say something strange is going on inside the Eurozone inventory cycle.  The inventory-led bounce is likely to be short-lived because a worrying gap has started to build between companies' assessment of inventories and their view on demand, i.e., order books.  Historically, both demand and inventories have moved closely together.  But in this cycle, they started to diverge about half a year ago when companies became more optimistic on their inventories - - probably on the back of previous aggressive cutbacks. So far, however, companies have only reported a small improvement in their order books.  As a result, a sizeable gap between inventories and orders has emerged.  This gap can be closed in two ways: either demand catches up or inventories are viewed less optimistically. 

The economists say this could be a warning sign for a double-dip.  Stagnating order books, correcting output plans and slowing current production reported in the September business surveys already signalled that the recovery could be losing momentum.  Hence, the near-term upside risks stemming from the inventory cycle do not make them more confident about the medium-term recovery. On the contrary, inspection of country data shows that those countries for which MS GDP indicators signal the largest upside risk are also the ones that have the biggest gaps between inventories and order books. 

Implications of a near-term growth spurt for the ECB policy outlook:  Currently, the ECB staff is projecting GDP growth to only average 0.2% next year whereas the new MS full-year forecasts would suggest upside risks to these projections of a full percentage point. Such a noticeable upgrade in the full-year growth projections could potentially trigger a change in the ECB's assessment of its monetary policy stance.  It does not necessarily have to trigger a change in the tone of the introductory statement, though, as the staff projections aren't underwritten by the ECB governing council.  If the ECB staff share the MS view on the upside mainly being down to the inventory cycle, the monetary policy implications might also be minimal.  But they could still spook markets.

New ECB staff projections aren't due before the December meeting.  However, it is possible that ECB President Jean-Claude Trichet will want to prepare markets at the November press conference.  By the time of the December meeting, the ECB staff will also have a much better handle on indirect tax hikes planned across the Eurozone and their implications for HICP inflation in 2010.  Given the rising budget pressures, the economists say they would expect these to make a more meaningful contribution.  In addition to factoring in the new staff projections, the ECB Council will have to decide on the interest rate at which the next one-year tender conducted in late December will be offered.  It could potentially decide to offer it at a small spread over and above the benchmark rate of 1%.  In sum, the December ECB meeting could potentially ring in an important change from the dovish tone characterising the last few press conferences.  That said, the economists continue to see the ECB on hold until around mid-year - - possibly even longer.

Country Forecast Highlights

France - Taking Stock of the Inventory Cycle

The short-term outlook for France has improved notably.  MS now expects 2010 GDP to grow by 1.7% in 2010,up from their previous forecast of 0.9%.  This is mostly due to a likely boost to GDP growth in Q309, which will raise 2009 GDP from our previous expectation of -2.2% to -1.8%. France has weathered the global recession better than any other major Eurozone economy, contracting by just over 3% from peak to trough compared with a drop of twice that size in Germany.  Two factors account for the lesser decline - - France's more limited reliance on exports and the resilience of the French consumer.  Conversely, the industrial sector suffered as much as in Germany.

However, the recent pick-up in industrial production suggests that economic activity might accelerate between Q3 and Q4. In the scenario that MS envisages for the remainder of this year, the main driver behind the pick-up in GDP growth is that manufacturers are likely to replenish their stocks of inventories after sharp cuts this winter, as suggested by the various business surveys - - ranging from the INSEE business sentiment to the manufacturing PMI (Purchasing Managers' Index).

The upshot is that the so-called hard data, especially on the manufacturing side, are likely to surprise on the upside over the next few months.  Morgan Stanley's proprietary GDP indicator points to an increase in Q3 GDP by 1.1%  - -which now happens to be its official forecast too. 

Italy - Manufacturing Catch-Up

The data flow turned decisively positive in Italy. MS has revised their  2010 GDP forecast from 0.6% to 1.2%.  While H209 is shaping up as much stronger than could have been envisaged only a few months ago, the medium-term view has not really changed. 

The economists now predict a contraction this year of 4.5% versus a previous forecast of -5.1%, on the back of a brighter short-term outlook for the industrial sector.  For example, industrial production had a 7% monthly gain in August - - the strongest rise in 30 years - - dwarfing the median forecast of 1.5%.  What's more, this followed an upward revision to the previous number from 1.0% to 2.4%.

This points to sizeable upside risks to Q3 GDP growth.Even assuming a payback in September as big as the gain in August, industrial production is likely to have increased by around 5% in the third quarter  - - after five quarterly contractions in a row.  Morgan Stanley's proprietary GDP indicator also points to a quarterly gain of 1.2% in Q3  - - far above the latest published consensus forecast of 0.5%.

The economists say this forecast already factors in notable downside risks.Most of the boost in Q3 is due to companies re-building their stocks after severe cuts this winter.  This means that this impulse will fade away once companies feel that their stock of inventories is adequate.  MS expects GDP growth to be flat in Q4 and to average about 0.3% per quarter next year.  In addition, Italy is - - together with France - - -the major Eurozone economy with the biggest discrepancy between the assessment of inventories and orders.  This suggests that companies expect demand to remain weak.  The pick-up in economic activity might turn out to be very short-lived, unless more fundamental drivers of growth kick in.