Irish Q2 GDP; Deflation re-emerges.

Irish real  GDP contracted in the first quarter, by 2.1%, and the latest CSO data shows a modest  0.6% recovery in q2. Nominal GDP fell however, by 1.0%, which followed a 5.6% decline in the first quarter. Consequently, the consensus forecast for nominal GDP in 2016 is probably too high as indeed are forecasts for real growth of 4.9% and the coming weeks are likely to see some downward revisions.

Consumer spending was weak in the second quarter, declining by 0.5% in volume terms, and  business spending on machinery and equipment also fell, by over 10%. Exports, too, declined, albeit marginally. This broad weakness was offset by a 5% rise in construction and a surge in spending on R&D ( including patents and licences) which is classed under ‘intangibles’ . The latter component is extraordinarily volatile and actually more than doubled in the quarter alone ( +113%) , and as such  was the main factor behind the 39% rise in total investment spending. These intangibles are largely multinational and often purchased from parent companies abroad, so imports also rose strongly in the quarter, by 12%. There was also a postive stock build, adding 1.3% to GDP, although the sum of the components imply that real GDP actually fell, with a large statistical adjustment accounting for the positive growth figure.

On an annual basis real growth in q2 emerged at 4%, and the first quarter figure was revised up to 3.9% so giving an average for the half year also around 4%. Real GDP rose by 5.5% in the final two quarters of 2015 and that  base effect implies that annual growth may slow substantially in the second half of 2016, with the average for the year likely to be well below the 4.9% assumed by the Government.

Similarly, the nominal level of GDP in 2016 is also likely to be lower than anticipated, largely because export prices are falling . Consequently, nominal GDP only grew by an annual 0.5% in q2 , which followed a 1.5% rise in q1. On that basis nominal GDP may be largely unchanged in 2016 or indeed may even decline, with implications for the debt and deficit ratios.

Overall, a mixed bag. The real economy avoided recession , which was a risk given falls in retail sales and industrial production in q2, but deflation has re-emerged, via export prices.

Are current euro sovereign yields irrational?

The Irish Government issued a 15-year bond recently at a yield of 2.49% and the 10-year benchmark is trading at under 1.6%, a far cry from the double digit levels seen in the latter just a few years ago. Sovereign yields across the euro area have plunged of course ; 10-year yields in Italy are down at 2.3%, Spain is trading at 2.1% while Portugal is just over 3%.The perceived risk of default  over the next five years has clearly changed dramatically and judging by Credit Default Spreads is now around 10% for Italy, 17% for Portugal and less than 5% for Ireland.

German yields are lower still and bund yields can be considered the nearest thing to a risk-free rate in the euro area. Consequently, a 10-year bund rate of just 0.8% implies that the market expects short term  euro interest rates to stay low for a long time and then to rise only slowly; the implied 5-year forward yield in five years time is under 1.5%.Interest rates are also extremely low in other currencies but higher than bunds, with the US 10-year yield at 2.34% and the UK  trading at 2.1%. The 5-year forward rates also tell a  very different story- the US implied yield is just over 3% , with the UK at 2.8%.So the bund curve indicates  that investors expect inflation to stay low for a long time and not to threaten the ECB’s 2% target. This , in turn, indicates an expectation that growth will remain weak in Germany, with the prospect of  secular stagnation clearly seen by many investors  as more than just an academic debating point.

That scenario  may or may not materialize but it would appear to be a plausible rationale for the current level of bund yields. The problem is , though, that such a scenario would be very negative for other euro zone economies, particularly those with extremely high debt burdens and needing an internal devaluation to become more competitive within the zone. A prolonged period of very low nominal GDP growth, possibly with price deflation, would severely damage fiscal capacity and via the denominator put further pressure on already stretched debt ratios; Italy’s ratio in q2 of this year  was 134% , for example, with Portugal at 129%.Indeed, Italy’s GDP is already falling steadily and in real terms is back to the level recorded in early 2000.

Buyers of peripheral euro sovereign bonds can point to Draghi’s ‘whatever it takes’ mantra and  it would seem that the market views full-blown QE (i.e. buying sovereign debt)  by the ECB as inevitable and that somehow this will save the day. The Governing Council is clearly split on the issue, however, and some opposed the current plan to buy Asset Backed securities which explains why Draghi is at pains to add the qualification ‘within our mandate’ to his statement that there is unanimous support for additional non-standard policy measures.- clearly some members feel that the ECB could be acting ultra vires. So QE is not inevitable but if it did emerge (through a majority vote perhaps) it is still problematical relative to experience elsewhere. The banking system in Europe  is the main source of credit, unlike the US where the disintermediation of banks is the norm, so QE may not have much impact. Moreover Central banks in the US, the UK and Japan have bought their own sovereign bonds but the ECB has no sovereign bonds to buy- it would have to choose among the sovereign bonds of the 19 member states. How would it proceed if it chose a €1,000bn target- would it buy in proportion to the country weights within the euro area, or target higher yields? The former would imply the purchase of large amounts of  bunds and say only €12bn of Irish bonds. In addition the ECB would be buying at extremely low yields ( elevated prices) so adding a high degree of market risk to the credit risk inherent in QE.

More fundamentally, transferring ownership of some sovereign debt from one group of investors to another (in this case the ECB) does nothing to change the debt burden unless of course one believes that the ECB will effectively tear up the bonds or hold to maturity and then pass the proceeds back to the respective governments. One doubts if that would be acceptable to the Germanic school within the Governing Council, at least on any scale that would make much difference to high debt countries, but such concerns do not seem to weigh much on investors at the moment.