European growth cools as surging euro takes toll

German industrial output fell by 1.1pc in June amid dieselgate scandal and as exports feel currency pain

THE eurozone’s economic boom this year is already starting to cool down as the surging euro takes its toll on export industries and the recent fiscal boost wanes.

German industrial output fell by 1.1pc in June from a month earlier – the first drop this year – and the latest Sentix gauge of investor expectations for the eurozone fell sharply. The reading for Germany dropped from 12.5 to 5.8 in August amid deepening worries over the diesel scandal in the car industry. “It has become increasingly clear that economic momentum has passed its high point,” said Manfred Hubner, from Sentix.

The euro has jumped by 12pc to $1.18 against the US dollar this year as the currency bloc enjoys the best growth since the global financial crisis. This is an enormous move for the two anchor currencies of the global system, and it is having very powerful effects on global liquidity.

While markets are starting to anticipate tighter monetary policy in Europe, they have at the same time lost faith that Donald Trump will deliver on infrastructure stimulus or serious tax cuts this year – implying looser monetary policy in the US than previously expected. “We have been in a perfect storm for the euro/dollar,” said Martin Enlund, from Nordea. He warned that if the euro hits $1.25 soon this may cut the eurozone inflation rate to 0.6pc in 2019 – or near zero if oil prices stay low – and leave the European Central Bank with no safety margin against a deflationary shock.

“The question is when the ECB will react to these developments,” he said. Mr Enlund said it will take 18 months for the currency effect to feed through to the real economy. “It all points to a slowdown next year.” The exchange rate has risen 6pc in trade-weighted terms since early May. This is already eroding corporate earnings on European bourses. Germany’s DAX index of equities and France’s CAC 40 have both slipped 4pc since then. Corporate treasurers have budgeted for an exchange rate between $1.08 and $1.13 for this year, and are not fully shielded on the derivative markets.

The twist is that some countries will be hurt more than others. The International Monetary Fund said in its latest External Sector Report that (as of late 2016) the euro exchange-rate was 15pc undervalued for Germany, but

‘It has become increasingly clear that economic momentum has passed its high point’

overvalued by 7.5pc for Spain, 6pc for France, and 5pc of Italy. The situation has since deteriorated for the weaker states. The Club Med bloc as a whole is roughly 15pc overvalued.

The enormous gap shows how little convergence there has been since the eurozone debt crisis erupted. The strategy of forcing the South to claw back lost competitiveness through austerity and deflationary policies certainly caused high unemployment but has been a painfully slow way to close the gap with Germany.

“The euro has ended in a massive disequilibrium. The lesson is clear: internal devaluations do not work. In these conditions, only exit from the euro can solve the problem. Otherwise it is death from deindustrialisation,” said Professor Jacques Sapir, from l’école des Hautes Études in Paris.

Hans Redeker, from Morgan Stanley, said the euro could rise much further as Japanese and Swiss money managers

regain confidence in the EU project and cease to roll over their protective currency hedges on eurozone assets. This shift in behaviour acts as a propellant for the euro. They are in effect closing their euro “short” positions, and on a large scale.

Mr Redeker said the eurozone economy can withstand a much higher ex- change rate – perhaps $1.35 – at a time when global trade is expanding at a brisk clip, with commodities recovering and emerging markets seeing the strongest capital inflows since the Lehman crisis.

“Our indicators show global growth rising to 4.3pc over the next half year. This is the best since 2010. The weaker dollar is loosening monetary conditions across the world,” he said.

There is a whiff of events a decade ago when dollar liquidity was flooding into emerging markets, causing countries to amass foreign reserves and hold down their exchange rates. This automatically led to internal stimulus and overheating. In this giddy climate, eurozone exporters may have a high tolerance for stronger currency.

The weak link in the chain is Italy, which has a high export “elasticity” to the exchange rate and competes head on with China and emerging Asia in mid-tier industries. The political landscape is volatile as elections approach early next year, and the public is outraged by EU failure to help tackle the migrant crisis.

The anti-euro trio of the Five Star Movement, the Lega Nord, and Brothers of Italy are together running at almost 50pc in the polls, while the resurgent Forza Italia has eurosceptic tinges. “We think that the risk of an exit will hit Italian financial markets as the election approaches,” said Jack Allen, from Capital Economics.

Markets have lurched from extreme pessimism about eurozone before the French and Dutch election, to the opposite view that populism has been defeated. In reality, little has changed. Emmanuel Macron was elected on a very narrow base in France and his honeymoon is already over. He is running into the same immovable obstacles as his predecessors. Tensions remain just below the surface.

Any political upset in the eurozone could shift sentiment suddenly in the currency markets. The Republicans may yet deliver a tax cut in Washington this year, just as “quantitative tightening” by the Federal Reserve gets under way. Events may conspire to set off a powerful dollar rally when people least expect it.