Euro Area

Prospects Daily: Spanish and Italian bonds advance…Investor confidence in Germany rises strongly..

Financial Markets…Spanish and Italian government bonds bounced back from their earlier losses, with their benchmark 10-year yields dropping 6 basis points to 5.17% and 4 bps to 4.36%, as a report showed German investor confidence surged to the highest level in nearly three years this month, boosting risk-appetite for the region’s high-yielding debt. Notably, Spain sold €4 billion ($5.35 billion) of 3- and 9-month bills with an average yield of 0.421%, down from 0.441% in January auction.

Asian equities advanced on Tuesday, with the benchmark MSCI Asia Pacific Index heading for an 18-month high closing, amid robust corporate-earnings reports. But gains were somewhat limited on worries that Chinese government will try to cool the property market, pushing China’s Shanghai Composite Index lower by 1.6%.

The Standard &Poor’s cut its sovereign credit rating on Tunisia by one level ‘BB-‘ (three notches below investment grade) from 'BB', citing increased political risk in the wake of the February 6 assassination of a prominent leftist opposition politician, Chokri Belaid. The downgrade was the third one by the rating agency since January 2011.

High-income Economies…Investor confidence in Germany rose to a three year high in February, with the ZEW Indicator of Economic Sentiment, jumping to 48.2 in February from 31.5 in January. This was the third consecutive increase for the index which aims to predict economic developments six months in advance, and the highest reading since April 2010. Economic expectations for the euro area climbed 11.2 to 42.4 in February.

Greece’s current account deficit narrowed sharply to €0.54 billion in December from € 0.85 billion in November helped by falling imports and lower interest payments after a sovereign debt cut. For the year as whole, the deficit shrank to 2.9% of GDP in 2012 from 9.9% the previous year - its lowest level since 1999 when it joined the euro.

Construction output in the Euro Area continued to fall in December, declining by 4.8% (y/y) compared to 4.7% in November, led by weakness in Portugal, Poland, Bulgaria and the UK. On a monthly basis, output decreased 1.7% (m/m) in December, after dropping 0.4% in the previous month.

Developing Economies…East Asia and Pacific: Thailand’s GDP grew briskly by 3.6% (q/q) in Q4 of 2012, up from 1.5% (q/q) in the previous quarter. Growth for the full year came in at 6.4% up from 0.1% in 2011, reflecting strong domestic demand following the government’s stimulus post 2011 floods.

Europe and Central Asia: Russia’s retail sales slowed in January, growing by 3.5% (y/y) compared to 5.5% (y/y) in December. This is the slowest pace in 35 months as private consumption is weakening.

Latin America and the Caribbean: Mexico’s GDP growth accelerated in the Q4 growing by 3.1% (q/q, saar) up from 1.4 (q/q, saar) in Q3. Growth for the entire year was flat at 3.9% in 2012 as strong domestic demand offset weaker exports.

Middle East and North Africa: Tunisia’s industrial production accelerated in November 4.2% (y/y) compared to 0.3% (y/y) in October 2012. Higher growth partly reflects base year effects, with the expansion led by growth in energy production and manufacturing.

Sub-Saharan Africa: Nigeria’s inflation dropped to 9% (y/y) in January from 12% in (y/y) in December 2012 bringing inflation in line with the central bank’s target (<10%).

The looming US “fiscal cliff” is one of the main downside risks to the global economy in 2013, with Latin America and East Asia and Pacific to be among the most affected if it materializes. Several developing country central banks have eased monetary policy in recent months on concerns about the growth outlook, but they may now pause as growth is expected to pick-up and as they assess the impact of the monetary easing in high-income countries. Precious metal prices have risen sharply on supply concerns, related to labor disputes in South Africa’s platinum mining sector, and on higher investment demand, related to uncertainty about the global outlook and the Federal Reserve‘s quantitative easing QE3.
One of the main downside risks to global growth is the looming US “fiscal cliff”. Automatic tax hikes and spending cuts are set to take effect starting in 2013 if the US Congress fails to agree on an alternative debt-reduction plan. The US’s Congressional Budget Office forecasts that the US fiscal deficit will decline 3.3 percentage points to 4% of GDP in 2013. In the event the full “fiscal cliff” materializes we estimate global growth will be 1 percentage point weaker than our revised 2.6% forecast (which assumes that only about 30% of the fiscal cliff will materialize), as US growth would be 2.2 percentage points lower in 2013 at -0.2%. The Euro area would also fall back into recession, as output is expected to decline by 0.4 percentage points relative to the baseline growth of 0.3%. Growth in developing countries would be 0.6 percentage points lower in 2013 with the more open economies and the ones that have strong economic linkages with the US being the hardest hit.
Concerns about growth following disappointing outturns in 2012H1 prompted several developing country central banks to ease monetary policy in July-August. Central banks of several developing countries, including Brazil, Colombia, and the Philippines cut policy rates between late-July and August. Brazil’s easing cycle was one of the most aggressive, (500 bps since August 2011), slashing the policy rate to a record low of 7.5% by late-August. In contrast Russia’s central bank raised its policy rates by 25 bps, the first hike in 16 months, on inflation concerns. We expect developing country central banks to remain on hold over the next months, given the expected pick-up in growth in Q4 and as they pause to assess the impact of monetary easing in the US, the Euro Area, and Japan. In China, concerns about growth deceleration in the context of low inflation may prompt further easing. If investors’ appetite for riskier assets intensifies, bringing hot money back to emerging markets, central banks may cut rates further and/or impose capital controls to stem currency appreciation.
Precious metals have risen sharply on rising investment demand and supply concerns. The precious metals prices are up between 15% and 30% from the lows reached in the May-June period. Gold prices rose 15% to $1,770 by mid-September, matching the year-ago all-time highs, while silver and platinum prices rose 30.6% and 22%, respectively. Demand for precious metals by institutional investors (who are increasingly turning to platinum) has increased recently, following the Federal Reserve‘s QE3. In addition, labor disputes in several South African platinum mines that began a month ago and escalated in early September, have pushed platinum prices to 6-month highs.

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Important developments today:

1. European shares and euro continue to slump as Moody’s cuts the rating outlook for Germany, the Netherland, and Luxembourg

2. Output in the Euro Area contracts for the sixth month in July

Renewed Euro Area tensions cut into capital flows to developing countries in May and June, and prompted a sharp downturn in business sentiment worldwide. Together these developments point to slower growth in 2012Q2 and Q3, unless recent improvements in financial markets and policy steps cause business sentiment to strengthen. Falling industrial commodity prices, notably oil prices, may mitigate impacts for importing countries, but will exacerbate strains on government revenues in commodity exporting nations.
Capital flows to developing countries picked up slightly in June after falling sharply in May due to renewed Euro Area tensions. The resurgence of Euro Area turmoil in May caused gross capital flows to developing countries to fall by a revised 45% in May (solid line in figure). The bulk of the decline was in bond and equity issuance, as borrowers may have voluntarily delayed going to market given heightened uncertainty. In June, total gross capital inflows picked up somewhat. Perhaps surprisingly, in the most recent period syndicated bank lending has held up (despite European banking-sector deleveraging). Overall, inflows in May-June are down 36% from the levels observed in the first four months of the year. Should capital flows remain depressed they could contribute to weaker investment and growth in developing countries in the second half of the year.
The financial turmoil in the Euro Area has cut into business sentiment worldwide. Purchasing manager indexes (PMIs) published by national sources and Markit deteriorated further in June. The global indicator descended into sub-50 territory, suggesting that global output shrank in June, with all economic regions weakening (except China whose official PMI improved slightly). A similar decline in PMIs occurred in the second half of 2011, when Euro Area tensions rose in July of that year. Perhaps, reflecting lessons learned from that earlier episode, the deterioration has been quicker and more marked this time around. The decline in sentiment is consistent with a scenario where firms and consumers are holding back on expenditures because of increased uncertainty. Economic outturns for the second and third quarters of 2012 will depend critically on whether confidence remains weak or begins to strengthen in response to recent policy steps.
Euro Area tensions and global growth concerns have accentuated downward pressure on industrial commodity prices, notably oil prices. International prices of crude oil and other industrial commodities have been on a downward trend in recent months, reflecting strong supply growth and weak demand. The initial easing in prices occurred even as global economic activity was firming, but has accentuated with financial market tensions and expectations of weaker growth. As of July 3rd, international crude oil prices were $25 lower than their first quarter highs, and copper and aluminum prices were down 10 percent and 16 percent respectively. Internationally traded wheat prices have strengthened in recent weeks amid concerns that high temperatures may reduce global supplies, especially from key exporters including the United States and Russia. Compared with a year ago, wheat prices are up 15 percent and maize prices are up 14 percent. While lower oil prices will help to cushion the real-income effects of weaker GDP growth in most developing countries – lower oil and metal prices can be expected to cut into incomes and government revenues in exporting countries, exacerbating the downturn in those economies.