Hidden Storylines in Eurozone Q2 GDP

One day after the US announced Q2 GDP results, it was the eurozone’s turn Friday—and surprising many, its results were much better. Where the US contracted last quarter, eurozone GDP grew 0.7% q/q (2.8% annualized), smashing expectations for a 0.1% q/q rise.^[i] That generated a heap of headlines, a few sunny on the positive result while most warned the fun won’t last now that Russia has reduced natural gas flows into the region substantially. We can’t help but wonder what all the fuss is about on both sides, considering headline eurozone GDP is next to meaningless. It is the sum of 19 individual member state GDPs, often with too many offsets among them for the total to be of much use, especially to investors looking for economic clues. This quarter’s results are a prime example.

So far, only nine eurozone member states have reported. Their results range from a -1.4% q/q contraction (Latvia) to 1.1% growth (Spain).^[ii] But whenever investors look at Continental Europe, they are mainly eyeing four countries: Germany, France, Italy and Spain, the four largest economies. Of these, people view Germany as the engine, France as a ride-along and Italy and Spain as the periphery. So, if Germany is struggling, that tends to color the view of the whole and raises questions about whether other nations will soon follow.

This is the primary concern today, as German GDP was flat in Q2 (or, as Bloomberg pointed out, ever-so-slightly contractionary when you round to 2 digits versus 1).^[iii] This follows 0.9% growth in Q1, which stemmed largely from post-Omicron reopening boosting the services sector, and an Omicron-related -1.4% Q4 contraction.^[iv] Germany’s Federal Statistics Office doesn’t release a detailed breakdown in its first estimate, but the accompanying commentary said consumer spending rebounded while net trade detracted. Whether the latter involves rising imports, another drop in exports or a combo thereof, we will have to wait and see.

But even if it proves to be a math quirk that caused Germany to stagnate rather than continued weakness, it is likely of little import to markets, which are forward-looking and have fresher German headwinds to deal with. That headwind is the aforementioned Russian gas flows, which are now down to about 20% of normal. This is bad news for Germany, which relies on Russian gas not just for home heating and other general energy needs, but as feedstock for its mighty chemical industry. Already this week, one chemical giant reported it has cut ammonia production in order to conserve gas use. Positively, this enables the company to feed gas into the grid, but if more production goes offline, it could cause heavy industry to contract further as the year rolls on.

That would be bad news for Germany’s economy. Yet bad news for the economy isn’t always bad news for stocks if they already reflect that bad news. The prospect of a natural gas shortage hampering German industry isn’t new. It has been one of investors’ foremost concerns not since Russia invaded Ukraine, but since last August, when Russia first started throttling supply through the Yamal pipeline. At the time, geopolitical analysts presumed Russia was trying to goad German and EU leaders into giving the Nord Stream 2 pipeline the final seal of approval. In retrospect, it may have been an early test of Russia’s leverage in advance of the Ukraine invasion. Whatever the motive, though, the initial reports of constrained supply roughly coincide with German stocks’ mid-August peak in dollars. From then through the most recent low on July 13, the MSCI Germany Index fell -35.5%.^[v] The rest of the eurozone is down much less over the same period. This suggests markets have long been pricing in Germany’s extraordinary vulnerability to gas shortages, making it likely that gas-induced economic weakness from here merely confirms what stocks already knew.

As for the rest of the big four, the results were positive overall but mixed under the hood. France grew 0.5% q/q, but household spending fell for the second straight quarter (-0.2%), and imports’ -0.6% slide also implies some weakness in domestic demand.^[vi] Still, business and residential real estate investment grew for the second quarter in a row, and the return of tourism post-Omicron helped exports stay strong. In Italy—which, like Germany, releases only general commentary in the preliminary estimate—heavy industry and services did well, and domestic demand was overall up. That all helped GDP grow 1.0% q/q, a nice acceleration from Q1’s Omicron-related 0.1% crawl.^[vii] Spain, the GDP winner so far, also got a reopening boost in consumer spending, which rose 3.2% q/q, and investment in tangible fixed assets, which jumped 3.4%.^[viii] But the real star was tourism, which surged a whopping 126.7% q/q as COVID restrictions lifted.^[ix]

Headlines argue this Club Med party is temporary, and soon German weakness and the fading reopening bounce will bring a malaise. We agree, to an extent. Worldwide, we have seen reopening boomlets each time restrictions end, and they are always short-lived. So we don’t expect tourism to double every quarter, and domestic spending on leisure probably slows once the thrill of finally going out starts to fade and people revert to normal habits. We also aren’t totally sure how statisticians are adjusting for spectators’ full return to major international sporting events, which each of these countries hosted in Q2 (e.g., the French Open in Paris and Formula One races in Spain and Italy). These events’ being cancelled and/or closed to fans in 2020 and 2021 could very well be messing with the seasonal adjustments, lending some artificial upward skew to Q2 results. Behavior and math returning to more normal patterns probably lends some slowness.

If the reaction to July Purchasing Managers’ Indexes is a good guide, people will likely have a hard time distinguishing between a return to pre-COVID norms and energy shortage-induced weakness if growth slows from here. But here are some general things we do know. One, we have ample evidence of economic weakness in individual eurozone nations not spilling over into neighbors. Italy, Spain and France don’t depend on German demand. All three are diverse, big, globally integrated economies. Tourists will visit the great museums and cathedrals whether or not Germany is producing chemicals and automobiles. Two, all three are more insulated from Russian energy. Spain has its own natural gas supply lines and is already eyeing the loophole created for it in the EU’s voluntary natural gas conservation agreement. France gets most of its energy from domestic nuclear reactors. Italy’s crude oil imports come primarily from across the Mediterranean Sea, and it has gas pipeline links with Algeria, Libya and Azerbaijan. Hence, the economic risk of Russia’s retaliation to EU sanctions is lower for all three than Germany.

This doesn’t get much attention, however, which is positive—it drags down expectations, making positive surprise easier to achieve. Right now, forecasters are increasingly penciling in a 2023 recession for the eurozone overall, foreseeing weakness in Germany and Southern Europe alike. If Germany gets a shallow recession and everyone else muddles through, which we see as a realistic possibility, that would be a positive surprise indeed. We aren’t making a 2023 forecast, mind you, but showing how wide the gap between expectations and reality appears to have grown. Europe may not be firing on all cylinders, but it doesn’t need to be for stocks to enjoy a recovery.