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Economy in Brief

EU Commission Indexes Hit Record -What's Next?
by Robert Brusca  July 29, 2021

The EU Commission index for all of the EMU hit a record high in July rising to 119.0 from 117.9 in June. Four of five sectors have rankings in their top 90th percentile decile. The services sector comes up just short of that ranking with a still-impressive 89.6 percentile standing. Eight of eighteen countries have percentile standings in their top 90th percentile decile as well. Only Slovakia is below its historic mid-point (below a ranking of 50) although Portugal at 53.7% comes close; Cyprus’ rank is at its 57.7 percentile.

Compared to January 2020, just before the Covid virus struck, there are only four countries that are still weaker than that January value, they are: Cyprus, Slovakia, Portugal and Lithuania. Only one sector, construction, is weaker than its January 2020 value.

There is a strong correlation with how well a county has grown from its January 2020 level and the absolute ranking of its current sentiment index. The correlation between the two gauges is 0.82. The chart makes this result quite clear at least for the largest EMU economies.

This month’s record reading for the EMU has been achieved despite step-backs by 11 of 18 reporting EMU members on the month. This record is substantially because a proliferation of small and medium sized countries stepped back while the large countries continued to improve. Each of the Big four economies advanced in July led by a 3.5% rise in France and with a small 0.3% gain in Germany and with increases of about 1.5% in Italy and Spain. Belgium, Greece and Estonia also showed month-to-month increase in July.

Of the five sectors only two of them made gains in July, the industrial sector and services. Two sectors weakened, consumer confidence and construction. Retailing’s assessment was unchanged.

Based on the breadth of support across sectors and countries, it looks like the index may not be continuing to push ahead next month. This month’s improvement was on the back of a few large countries with far more countries weakening and with sector performance split. The virus is back in play and we will have to watch to see how that shakes out.

Momentum
There have been some big changes in momentum over just the last three months. The ranking for Slovakia has fallen by 42.5 points, the ranking of Malta has fallen by 20.5 points and the ranking of Portugal has fallen by 19.5 points. But by and large, the news has been of improving rankings. Greece, Italy, Latvia, and Lithuania post ranking increases of nearly 20 points over the last three months. Estonia and France have gains of about 15 points. Germany logs a gain of 10.7 points in its ranking.

By sector, over three months the biggest improvement in standing is the 31.1-point gain in services followed by the 25.7-point improvement in retail as consumer confidence ran up by 11.5 points. This second wave of improvement clearly has been on the back of the services sector and owes to vaccinations to a large extent. That is why with the variant-Delta rearing up, progress is threatened. Over the last three months, the industrial reading and construction reading each improved in total by only about 1 ranking point apiece.

Changes in sentiment indicators
Looking at the changes in the sentiment indicators by country over 12 months, six months and three months, Slovakia, Latvia, Lithuania, Slovenia, Luxemburg and to a slightly lesser extent Portugal and Spain have been laggards with persistent rankings on changes in their sentiment indexes among EMU members at the back of the pack (rankings of 11 or higher out of 18).

Italy has been the strongest over these horizons ranking first or second over 12 months, six months and three months followed by Austria and France. Germany on this timeline has an average point change ranking of about 6 out of 18 which is solid but not stellar.

The index point changes by sector shows the services sector has been consistently the strongest followed by the industrial sector, retailing, and with construction gains stronger than consumer confidence on all timelines except over three months.

Sector performance among large economies
Looking at the rank standings by various sectors across the largest EMU members, Germany’s overall sentiment gauge is the highest. However, the unweighted average across sectors is highest in Italy, with Germany and France neck and neck for second place. Spain finishes a poor fourth and that is because it finishes with the weakest sector rankings for each and every sector among this group. Italy ranks first or second for each of its sectors ranking second to Germany only for industry and retailing and on the strength of those two Germany ranks higher than Italy for overall EU sentiment.

Summing up
On balance, there is a lot of progress in the EMU but also some significant retrograde motion or just nagging weakness for Spain, Portugal, Malta, and Slovakia. To a lesser extent, Slovenia and Luxembourg also have fallen on tough times recently. Spain, Portugal and Malta have been experiencing some increases in infections recently.

The ECB and the Fed have within the past year recalibrated their monetary targets in such a way as to put the focus on letting growth run a bit hotter. For the Fed this is an explicit goal for the ECB it is implicit, but the message is clear: the ECB has pushed to hit a 2% average inflation target rate rather than to aim to keep inflation close to but below 2% persistently. Currently inflation in Germany is flaring sharply partly as a result of base effects stemming from actions taken to fight off the virus. Even so, Verdi, a large service sector union, is now calling for a strong increase in wages to compensate workers for inflation’s erosion. This is the sort of thing that makes inflation look increasingly less transitory.

Expectations, behavior, and reality
This is the sort of thing, the behavior and perceptions of market participants, that is hanging in the balance and being ignored. If these change, it will make it difficult for central banks to keep the tooth paste in the tube after inflation has emerged- as it is doing. Central banks are focusing on expectations which are often sort of wishy washy. They are very important if they are strongly held and if workers and firms are making plans off those expectations. But perhaps more germane to policy is how much the flaring in inflation is going to change behavior. The global economy may have much the same structure that it had before the virus struck, but if behavior changes the economic system could function very differently and in a way that is consistent with more inflation tolerance and less of an attitude by firms to try to hold the line on pricing. Why hold the line on prices when everyone is raising them? We are already seeing that play out in the German labor market. And there are other examples in the U.S. labor market where workers are trying to engage employers to implement wage hikes. If that effort is successful on a widespread basis, do we follow it with more price hikes...and then get more wage hikes? The old low inflation environment had prices standing guard as firms held the line to protect market share. That environment is now gone. Is it gone for good? If it is coming back, what will bring it back and reinstate that sort of discipline?

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