The Eurozone Follows the Path America Charted: Economic Update

The eurozone and several member-states released Q3 gross domestic product (GDP) Friday—and tossed in October inflation as a bonus. (GDP is a government-produced measure of economic output, and inflation is a rise in prices across the broad economy.) In our view, all largely follow the course the US charted when it reopened from COVID lockdowns earlier this year, and none of the results likely surprised stocks for good or ill. As we will show shortly, the results suggest reopening drove swift growth, whilst energy prices fuelled faster inflation. Both developments were widely expected amongst financial commentators, and both appear likely—to prove short-lived, which we think should prove fine for markets. Let us take each in turn.

Behold, the Reopening Boom!

Q3 GDP results for the eurozone and three of its four biggest member-states all accelerated from Q2, with the outlier—Italy—still notching double-digit annualised growth. (The annualised growth rate is the full-year growth rate that would result if the quarter-on-quarter growth rate repeated sequentially over a full year.)

Exhibit 1: Eurozone & Member-State GDP Growth

Source: FactSet, as of 29/10/2021. Annualised GDP growth, Q1 2021 – Q3 2021.

All outpaced the US’s Q3 2021 GDP growth, too, a factoid noted by most headlines we encountered. But in our view, that doesn’t mean the US is falling behind or that Continental Europe suddenly has the world’s most dynamic economy. Rather, we think eurozone nations’ apparent boom is a function of several governments’ decisions to implement tough second-wave COVID lockdowns earlier this year, which caused eurozone and some nations’ GDP to contract in Q1, as the table showed. We think the data indicate partial reopening aided Q2 growth, but most restrictions didn’t lift until summer—powering a consumption boom as people returned to shops, cafes and pubs as well as enjoying the delayed Euro 2020 soccer tournament. Although not every country has released a detailed Q3 GDP breakdown yet, Germany’s Federal Statistics Office noted growth there “is mainly attributable to higher household final consumption expenditure.”^[i] In Spain, household spending rose 10.0% annualised, adding 5.6 percentage points to headline growth.^[ii] French household spending jumped a whopping 21.5% annualised, contributing 10.5 percentage points to the headline rate.

As for the global supply chain crunch, we think there are probably too many distortions right now to isolate the impact. French business investment fell, but only -0.6% annualised, and it remains above pre-pandemic levels.^[iii] Exports and imports, by contrast, grew 9.3% and 0.5% annualized, respectively, but remain below their prior peaks.^[iv] In Spain, the only other major country with a detailed breakdown for now, business investment was strong across the board, but home construction fell for the fourth straight quarter.^[v] There, too, exports and imports jumped but aren’t quite back at breakeven.^[vi] In our view, we probably won’t get a clear look at the supply chain’s impact until next quarter, when the reopening boom likely tapers off—echoing the US’s trend. (US GDP growth slowed from Q2’s 6.7% annualised to 2.0% annualised in Q3.^[vii])

Most financial commentators couched the eurozone’s boom as a one-off, and we agree. Reopening is a one-time event, and as the US and China demonstrated, people tend to unleash pent-up demand quickly, then revert to more sustainable habits. We think this is likely to happen in Continental Europe as well. But as in the US, eurozone stocks didn’t appear to mind years of slow GDP growth between the 2011 – 2013 sovereign debt crisis and 2020’s lockdown-induced contraction.^[viii] We don’t see reason this time should automatically be different

Energy Explains High Inflation

Earlier this week, Germany stole headlines for notching its fastest inflation rate since the mid-1990s, October’s 4.6% y/y.^[ix] Now we have preliminary October data for all of its neighbours. Eurozone inflation accelerated to 4.1%, with Spain speeding to 5.5%, Italy to 3.1% and France to 3.2%.^[x] In our view, two simple words likely explain all of this: energy and reopening.

The ECB’s preliminary October release includes detailed data for the eurozone only—not member-states. But it does show energy prices rising 23.5% y/y and 5.5% m/m—accelerating from September’s 17.6% y/y.^[xi] That is no shock, considering the energy crunch continued in October, keeping natural gas and electricity prices elevated.^[xii] Oil prices also rose in the month as power plants turned to a more readily available fuel source.^[xiii] Excluding energy, though, prices’ acceleration was negligible, from 1.9% y/y in September to 2.0%.^[xiv] Interestingly, despite supply shortages, non-energy industrial goods prices actually moderated a tad, from September’s 2.1% y/y to 2.0%.^[xv] Services prices, however, sped from 1.7% to 2.1%, suggesting some reopening-related price pressures—much as our research shows the US experienced early this summer.^[xvi]

We won’t know for sure until detailed country data come out, but we suspect energy will likely deserve the credit for German inflation outstripping Italian and French. Energy’s weighting in Germany’s inflation basket, 7.4%, is significantly larger than its portion of France’s (5.5%) and Italy’s (4.8%).^[xvii] Spain’s exposure to energy costs is roughly in line with France’s, but its exposure to restaurants and hotels is almost twice as high—13.1%, compared to 6.7% in France.^[xviii] In the US, restaurants and hotels were a significant contributor to price pressures earlier this year, when demand for these services exceeded their limited supply as lockdowns eased. Those pressures faded, which we think sets a useful blueprint for leisure-heavy European economies.

As for energy, whilst we think higher prices are generally a headwind for household finances and heavy industry, those headwinds seem unlikely to last for long. Wind power generation has picked up lately, whilst natural gas and electricity prices are edging down.^[xix] The latter appears likely to get further relief from Russia’s recent decision to increase gas flows as well as China’s efforts to boost coal consumption, which we think is likely to remove some competition in global natural gas markets.^[xx] US and Canadian producers are also adding oil and gas supply.^[xxi] In our view, supply and demand seem likely to balance out sooner than many expect.

When that happens, we think inflation it likely to moderate. We don’t mean prices will fall—we mean the inflation rate will likely return to its slower long-term trend. A big reason for this: Eurozone lending isn’t on fire. Total private sector lending is hovering around its modest pre-pandemic growth rates—and business lending is considerably weaker.^[xxii] That means money isn’t changing hands quickly, so as soon supply shortages ease, we think prices will likely stabilise—as they have already started to in the US.