Europe's cycle follows the US, (normally)

Europe tends to follow the US business cycle with a few months lag. This has long been the pattern for Germany versus the US and, since 1999, has become the pattern for the euro area as a whole too. The lag is most clearly seen in unemployment. I have marked the turning points in 2001, 2003 and 2007 where US unemployment changed direction and German unemployment followed, and the lag is 10, 17 and 10 months respectively.

This following pattern is one reason why, when Euro area data suddenly weakened in Q3 2018 and there was talk of a possible European recession in 2019, most analysts demurred. After all the US was still strong at that time and has only weakened a little subsequently. The other reason was that European monetary policy remains very stimulatory with interest rates below zero and quantitative tightening still far away. So why should Europe go into recession on its own?

Of course, the euro crisis in 2011-12 was a major exception to the usual pattern. The euro crisis was a home-grown disaster caused by the fixed currency euro area and so was a special case. A repeat can’t be ruled out if Italy pushes too hard or threatens to leave the euro area. But the point is that the US did not follow the euro area into recession in 2011. Europe is still a follower except when it trips up on its own.

So, what did cause the European slowdown last year? It seems a combination of factors including a temporary lull in car production due to uncertainty over the introduction of new emissions standards; the slowdown in China; low water levels on the Rhine restricting supply chains; the yellow-jacket protests which have damaged activity in France; and the confrontational policies of the Italian government which have led to stagnation in Italy. These depressants combined with an inevitable easing of the pace of growth after a torrid 2017 created some ugly numbers.

The second half slowdown has created doubts about prospects for 2019, though so far, most forecasters are still expecting growth will manage 1-1.5%, barring a new US recession. This is well below the 2.4% recorded in 2017 and forecast 1.8% for 2018 but is still above trend (0.8-1%) and enough to bring unemployment lower.

What is behind this optimism? Italy will continue to stagnate and the outlook for France has become less certain though most forecasters assume the yellow jacket protests will peter out. But household incomes in Germany and the other northern countries are robust as are house prices which should support consumer spending.

The main risk for a worse outcome is if business confidence fades, leading to a slowdown in investment. Suppose China’s economy does not respond to the massive stimulus of recent months. And suppose the hoped-for peace in the US-China trade war does not materialise. And suppose the recent market sell-off resumes. You could add in a no-deal Brexit to create more uncertainty. But assuming not everything goes wrong at the same time, the fundamentals for the euro area look sound enough and policy settings remain very stimulatory.

Fiscal policy which held back growth for many years is mildly expansionary now. Monetary policy remains extraordinarily expansionary by any standards. Interest rates are at zero or below and the ECB has promised to keep them there until the summer at least. Historically European interest rates tend to rise more slowly and by less than the US and similarly be cut more slowly. The current cycle is no exception with the US already 3 years into its rate hike cycle.

Euro zone money supply M3 growth has slowed from the 5% rate it maintained in 2015-17 to about 4% now, which is consistent with a slowdown not a new recession. It is true that purchases of bonds under the quantitative easing programme finished at the end of 2018 but a reduction in outstandings is still a long way away. Overall then, while Euro area monetary policy may be less easy than it was, it remains easy.

In summary the strong Euro zone rebound of 2017 has now faded but as

long as the US avoids recession and tensions in the euro zone don’t create another own goal, Europe should be able to keep growing above trend. Prolonged weakness in China would trim European growth but, absent a China crisis, should not cause a recession. Europe badly needs growth. Unemployment is still too high and weaknesses in banking systems, not just in Italy, still need time to resolve.