The outgoing vice president of the European Central Bank, Lucas Papademos, speaking to ECB president, Jean-Pierre Trichet, at a valedictory seminar in Papademos' honour, in May 2010.

Eurozone Q2 2010 Economic Growth: Economists have warned that the expected report on Friday of strong economic growth in the single currency area in the second quarter, should bring to mind an old adage in the world's most popular forecasting sport - - the weather - - where the elders keep reminding us that one swallow does not make a summer. The same holds true in business cycle forecasting: one bumper quarter does not make a robust recovery and investors are advised not to read too much into what likely was a very strong economic performance in Europe during the second quarter.  The European economy is not expected to be able to keep up the pace it showed in the April to June quarter.

Elga Bartsch and Daniele Antonucci, economists at US investment bank Morgan Stanley (MS), based in London, says it's true, there were clear upside risks to the GDP (gross domestic product) estimates for the quarter that just ended. They say given these strong outcomes for Q2 GDP, consensus estimates for European growth will likely be raised in the coming weeks.

Incoming data suggest that the MS current projections of GDP expanding by a non-annualised rate of 0.9%Q in Germany and 0.6%Q in the Eurozone are way too conservative. GDP growth could potentially be almost twice as high as the previous official forecast.

As a result, it looks highly likely that Europe has outpaced the US in the April to June quarter.  Whenever this happens, which is rare enough, it is noteworthy because the trend rate of growth in Europe is considerably lower than in the US.  If confirmed by the official data, the stronger Q2 dynamics would push the full-year estimate for real GDP growth to 1.5%Y from 1.2% for 2010 and to 1.3% from 1.1% for 2011. This upgrade does not mark a big shift in the MS core view that the Eurozone recovery will be uneven and creditless. 

Bartsch and Daniele Antonucci say there are several reasons for the sudden surge in EMU (European Monetary Union) growth. 

• First, there was a very favourable backdrop from a pick-up in global trade (led by strong EM [emerging market] growth) and a much weaker currency.  Together these two factors caused export growth to skyrocket.  The main beneficiary of the surge in global demand was the manufacturing industry. 

• Second, in the current cycle, manufacturing companies have managed their inventories very differently from any of the previous cycles.  For starters, they have been cutting their inventories of finished products much more aggressively in the course of the downturn.  In addition, manufacturers were more cautious in their restocking as the recovery started to take hold because companies continued to be sceptical about the sustainability and the stamina of the upswing.  For five consecutive months now, Eurozone manufacturers have been positively surprised by the robustness of the recovery.  A record share of manufacturers view their inventories of finished products as insufficient right now. 

• Third, unusually cold winter weather caused a greater number of construction projects to stop in early 2010.  Hence, the seasonal revival in construction activity in the spring was more pronounced than usual.  In addition, after such big swings as the ones which have seen during the course of the crisis, seasonally adjusting the raw data becomes an art, as it becomes increasingly difficult to distinguish between the underlying trend and the seasonal factor. 

• Fourth and finally, the unusually hot summer weather and the World Cup seem to have boosted retail spending in July.  While this will not affect Q2 GDP, it could likely provide a solid ramp into Q3.  So far, data on retail sales volumes for June have been issued.  But July retail surveys suggest a surge in sales in the month. 

None of these factors should have much staying power. The economists say soccer fans have gone back into their summer slumber now that the World Cup is over.  The skies in many European countries are covered by grey clouds again and temperatures have come down to more normal ranges.  Post the catch-up in the spring, the construction industry is once again facing tighter government budgets, falling house prices and difficult mortgage markets in many parts of Europe.  The impact of the restocking process on GDP growth has probably peaked too.  In Q1, inventories contributed 1.1pp to overall GDP growth and were the only factor supporting growth, as net exports and domestic demand continued to weigh on GDP growth.  It is the change in the change of inventories that drives GDP growth.  Hence, for an ongoing positive contribution from inventories to headline GDP growth, the pace of restocking needs to pick up quarter after quarter.  Given that the assessment of inventories had corrected for a few months before it bounced back again in July, this does not seem very likely.  In addition, manufacturing companies have continued to revise down gradually their output expectations.

Three years to the date since the credit crisis first began: David Blanchflower, professor of economics at the US-based Dartmouth College, and former member of the Bank of England's Monetary Policy Committee, joined CNBC to look at the economy on Monday:

Developments increasingly uneven between countries. Bartsch and Daniele Antonucci say closer inspection of the country details shows that much of the Eurozone strength is entirely driven by Germany and hence unlikely to last.  Take for instance the business survey results -- the most timely and most robust information available on economic activity in the Eurozone.  In July, for output expectations for the next three months, arguably a leading indicator, Germany is the only country among the largest six in which manufacturers are not expecting production to slow.  Germany is also the only country where manufacturers expect production to remain above par.  The other countries are projecting below-trend production growth between July and October.  A similar picture emerges when looking at the assessment of order books.  Only in Germany are the order books above their long-term average.  Elsewhere, order books are climbing but they still remain about 0.75 standard deviations below the long-term average.  When it comes to current production, a key series going into our manufacturing indicator, the July surge seems to have been broadly shared by all countries, except France, which has been reporting stable production for the last four months.  This might change soon though because France was the only country to report a sharp drop in inventories of finished products.  Germany and Belgium saw small declines, while Italy, Spain and the Netherlands reported rises, causing inventories to become less insufficient than before.  To sum up, the recent round of business surveys suggests a strong entry point into 3Q but a moderation in the course of the quarter. 

Several fundamental factors cause MS to be cautious on the medium-term growth prospects for the Eurozone. 

First, there can be no mistaking the coming budget cuts.  Spain, Portugal and Greece have phased in measures over the summer.  Other countries will follow suit with their 2011 budgets.  On an MS count, the discretionary austerity measures add up to around 1.2% of Eurozone GDP for next year. 

Second, the economists continue to be concerned about credit constraints caused by weak bank balance sheets.  The MS base case remains a creditless recovery.  But the unexpected sharp deterioration in credit conditions for corporate loans reported in the recent ECB bank lending survey and a further fall in loans to non-financial corporates found in the June money supply data underscore that the risk of a credit crunch remains in play.  They note that the bank stress test wasn't the circuit breaker that it could have been and the process of cleaning up bank balance sheets remains painfully slow. 

Three years after the onset of the credit crunch: “Ordinarily coming out of a recession you expect 3-4% growth and we’re going to be lucky to get something as high as 3%,” Zane Brown, of Lord, Abbet, said.

In recent weeks, new risk factors have emerged: a re-strengthening of the Euro is not included in MS forecasts.  So far, the economists have assumed that a weaker euro will help to offset the impact of the fiscal tightening on headline GDP growth.  Furthermore, Eurozone money market rates, the EONIA overnight rate and the three-month EURIBOR rates are moving higher.  But like one swallow does not make a summer, a moderation in growth after an inventory-fuelled bounce does not make a double-dip.

The economists say they differ from consensus on the consumer.  While consumer confidence, retail sentiment and labour market conditions are gradually improving, headwinds still lie ahead.  Employment growth will likely be sluggish as companies have not been laying off staff as aggressively as their US counterparts even though the Eurozone economy shrank more meaningfully than the US.  Wage growth is rather muted, and as many countries are trying to regain competitiveness with the Eurozone, this is not expected to change significantly over the forecast horizon.  Only in Germany has a discussion started on higher wage demands.  Further, disposable income will likely be dented by income tax increases and spending cuts (notably on social transfers).  In addition, real purchasing power should be dented by a weaker euro and higher inflation (partially fuelled by indirect taxes).  Finally, the deleveraging process on the part of the consumer has not even begun in the Eurozone.  In conclusion, MS finds it difficult to see more than tepid growth in consumer spending. 

Implications for the ECB and its Policy

While the Q2 GDP numbers will also come as a pleasant surprise to the ECB's own forecasting staff, the data are also backward-looking. In the view of the economists, there is little reason to change the fundamental view of a below-par recovery over the forecast horizon.  At the margin, a strong Q2 outturn means a slightly smaller output gap and hence less downward pressure on underlying inflation.  That there might be a little less slack in the economy is also echoed by the stalling unemployment rate, which is now hovering sideways at 10% of the labour force.  On the whole, though, these marginal changes are not big enough and more importantly not sustained enough to change the monetary policy outlook over the policy relevant horizon of 12-18 months.  MS therefore continues to expect the ECB to stay on hold until H2 2011.  As before, the economists do see a risk though that a spike in inflation in early 2011 to 2.5% could potentially cause the ECB to become somewhat more concerned about the outlook for price stability.