The industrial economy led the European economy down and it will likely be required to lead the economy back up. There are reasons to suggest this process of recovery could begin imminently. Why?
1) The scale of the downturn already
European manufacturing has been in a recession for a year. As we show in the chart below, German industrial production is running at –5% yoy. In the last 25 years we have only seen a worse outcome once, during the financial crisis. We have fulfilled the downturns of the 90’s and the 2000-2002 recession in both time and magnitude already.
We also highlight the US industrial production recession in 2016.
2) Base effects
Markets follow the second derivative. In November 2018, European industrial production was already running at –4.1% YoY. It is likely that a decent recovery in the second derivative appears from November this year. This apparent recovery can buoy markets, lift CEO confidence and in time, capital spending.
3) The car industry
The car industry has led the downturn and will need to recover to lead the upturn. Recent data has been mixed to slightly better. The industry’s order assessment has weakened but business expectations have improved.
EU car registrations were up 14% YoY in September, driven by favourable base effects.
The car industry has faced enormous disruption over the last 24 months. The new WLTP testing regime caused huge production volatility in 2018, with milder disruption this year as the new system was fully phased-in in September 2019. More importantly, radically changing EU legislation has caused a sharp change in the car makers’ product line-up. Tough new Co2 emissions have prompted a raft of new low emission models to hit the markets in 2020.
Government commitments to become zero emission economies in the future, the diesel crisis and changing tax structures have caused consumer confusion. Car purchases have been impacted by an absence of clarity on new technology, new tax treatment and the delayed arrival of low emission models due to appear in 2020.
The car industry is enormously important for the European economy, with automotive revenue representing 7% of EU GDP. Autos are obviously even more important for EU industrial production. Whilst 12% of all EU manufacturing jobs are automotive, the ripple effects of the industry are much greater.
Whilst the sentiment data is hard to assess, consumer confusion has very likely held back car registrations over the last 18 months. This confusion is not surprising. Governments encouraged diesel sales for many years, yet now diesel is facing outright bans in many cities. The speed of this volte-face, on what is one of the largest purchases a consumer makes, has been destabilising. Consumers are waiting for clarity. Many investors are ascribing some structural macroeconomic malaise to Europe’s economic weakness this year, particularly given the perception that the economy is late cycle. But the major economic weakness has been driven by manufacturing and the car industry has driven the bulk of this slowdown. The weakness has been caused by idiosyncratic and temporary factors.
Why have EU governments been so timid in launching incentive schemes for zero / low emission cars? The simple reason is that EU car makers, particularly the Germans, have not had the right product available so far. A large incentive scheme this year would have benefitted Tesla more than any other manufacturer. This changes next year. A slew of new models made by EU car makers will be hitting EU markets. Expect generous “cash for clunker” style incentive schemes for low emission vehicles in 2020-2021. This can amount to a broad fiscal stimulus under the umbrella of reducing Co2 emissions. This will re-ignite the car industry and in turn lift European industrial production.
4) Wider fiscal stimulus
Whilst there has not been much evidence of it in the 2019 data so far, Europe is producing some fiscal stimulus in 2019. Fiscal stimulus tends to arrive with a lag, and this could act to lift GDP towards year end and early 2020.
5) Easing financial conditions with high wage growth
Many EU loans are indexed off Euribor 6 months and Euribor 12 months with a spread. Euribor is down 20 basis points year over year. The sharp decline started in May. This easing will begin to be felt by the economy at year end.
German 10 year bund yields are also down 70 basis points year over year. This broad easing of financial conditions should support the European economy in 2020.
Wages are continuing to gently rise, up 2.7% yoy, which is a cycle high. Higher wages and easier financial conditions are likely to be a solid set up for EU growth in 2020.
6) Rising money supply
Money supply is rising again, with M1 now up 8.4% yoy. This tends to lead loan growth and GDP growth and is favourable for economic momentum in 2020.
7) The political reality
Many economists have spoken of the entrenched uncertainty from Brexit and Trump’s tariffs which has reduced capital investment. But as of now, hard Brexit appears to be off the table. A deal of any kind should cause capital investment to rise in 2020. Trump also has major incentives to reduce uncertainty and lift job creation going into his re-election in 2020. Political risk has been a major headwind for growth in 2019 but could become a tailwind in 2020.
Base effects, an auto recovery, fiscal stimulus, easier financial conditions, rising money supply and reduced political risk all suggest the risks to growth are beginning to move to the upside.
This is an historic opportunity to own EU value stocks at record discounts. Value has been outperforming since mid-August. We believe this outperformance is likely to continue.
Lightman Investment Management, Bloomberg, OECD Economic Outlook No 104, Nov 2019
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