Forget the alphabet, Berenberg is predicting a 'tick' shaped recovery

Recorded on 23 June

PRESENTER: The latest eurozone PMI readings for both the services and manufacturing sectors in June beat analysts' expectations. However, they both still remain below the key 50 line. Joining me to discuss the outlook for the Eurozone economy is Dr. Holger Schmeiding. He is the chief economist at Berenberg.

Let's just start with the PMI data. What did you make of the numbers? Should we be reading into them too much, given the wash of downgrades that we've seen in terms of estimates recently? Do you think we should be anticipating more data going forward to beat expectations as well?

DR SCHMEIDING: Yes, there is a pretty good chance that more data will also beat expectations. I would not quite take the PMIs at face value. At face value they would suggest that across much of Europe economic activity was still contracting slightly in June. This does not fit any of the other evidence that we have. I would say the real message of the PMIs is that things are much less bad than they were one-two months ago. They do fit the picture that the European economies are recovering and at the margin probably a bit better than we had hoped for two-three months ago.

PRESENTER: What kind of recovery are you expecting? Do you think it is more of a recession or could we be heading into a depression? Is this more likely to be a prolonged slowdown or are you looking for a speedy recovery?

Forget the alphabet, it is a 'tick' shaped recovery

DR SCHMEIDING: We are looking for a fairly speedy start to the recovery. None of the letters of the alphabet will do. It's not going to be a V, W, L, or U. We call it the ‘tick mark’ recovery. It goes down a lot initially, then it rises fairly fast as supply is switched on and then it flattens off. And the evidence so far is in line with that.

March, April were atrocious. Because of the easing of lockdowns May was already somewhat better and June seems to be shaping up fairly well relative to April. But even in June output in most economies is still 10-15% below normal, which is bad but much less bad than the roughly minus 30% below normal that we had in many places in April.

PRESENTER: You recently upgraded your growth forecast for the first time this year, more so in the US than in Europe. Tell us why you're a bit more optimistic towards the United States.

Fiscal support will help the recovery

DR SCHMEIDING: First, we simply had US data on retail sales, which were very good showing a 17.7 % bounce in the month of May following a significant increase in personal incomes in April.

In the US, interestingly, workers who have been laid off or are being furloughed seem to be receiving on average more money than they did when they were working. With very generous fiscal support in the US, the recession there was a bit shallower. The May rebound or at least start to the rebound seems to be a bit better than we see in Europe. The pattern is similar, just in the US it all happens thanks largely to the big fiscal boost - it all happens on a somewhat higher level.

PRESENTER: What about fiscal policy across different Eurozone countries? I mean what do you think governments should be doing and which countries are tackling the problem best?

DR SCHMEIDING: Germany is of course well-placed to tackle the problems; it has granted itself a huge fiscal stimulus. All in all, probably a good 10% of GDP spread out over a number of years.

Other countries have less fiscal room and are doing less. What we will be getting hopefully by the end of this year is this big European fund which by and large will enable those countries with less fiscal space on their own to do almost as well as Germany, as those countries will be getting the bulk of the support from the European level.

I think with these programs, the national programs we already have in the pipeline, and the European program that probably will be discussed but still be passed later this year, we are doing roughly enough in terms of fiscal policy. A little adjustment here and there would make sense. But I don't think we need another big stimulus on top of that, as the data are showing the economy is coming up anyway.

PRESENTER: What about monetary policy? Do you think that the ECB has been doing enough? Of course, we know there's the Pandemic Emergency Purchase Program (PEPP) that's recently been increased. Do you see that being increased further?

Will ECB increase PEPP further?

DR SCHMEIDING: For the time being, it has done enough. And then we have to see how the situation develops.

If the economy underperforms a little, or if inflation undershoots expectations, which is quite possible, then there would be a case for the ECB to add say another €500 to €600 billion to its pandemic emergency purchase program, a bit more than we have now may makes sense. But the real heavy lifting has already been done. And the real heavy lifting in a way is not the precise amount of purchases. The real heavy lifting has been the signal from the ECB: ‘We do all it takes to contain the recession, to contain the risk of a financial crisis, and to support the recovery’. Signals count for a lot as confidence matters for spending and business investment.

PRESENTER: Okay let's talk about the FX markets then because we've seen quite a big rally in euro dollar recently, about 6% since those mid-March lows. How bullish are you towards the common currency in Europe?

EUR/USD has more upside as USD safe-haven flows lessen

DR SCHMEIDING: I think euro has a bit more upside, but it is mostly a dollar story rather than a euro story. What happened in the very hot phase of the pandemic, when things were just getting worse and worse around almost the entire world, was that money was flowing into the perceived safe haven of the US dollar - often out of emerging markets. That drove the dollar up.

Now these flows are seizing for two reasons. To some extent, the hot money that could have left the badly affected emerging markets has already left them. Also, there emerging markets, which like Europe seem to be doing better in terms of stabilizing the virus trajectory, flattening the curve. Hence where there is no further reason to move money out.

With safe-haven flows into the US dollar lessening, and some outflows again into other countries, the dollar is normalizing and that should easily take EUR/USD to 115 or slightly above that by the end of this year.

PRESENTER: Finally, on the European equity markets - what's your take on the disconnect that we're seeing between those equity indices and the underlying economic strength? I mean do you think that equities are valued fairly at the moment - reflecting all of that stimulus both on the monetary and fiscal side as well as an expectation that we are going to recover sometime soon? Or do you think that this rally doesn't make sense, and something got to give at some point?

Markets are in disconnect with the economic reality

DR SCHMEIDING: Well a good part of the current disconnect is simply that March was an irrational panic which never made much sense. Things were bad in March, but they were never that bad to justify a 30-40 % sell-off in equity markets. Mostly the current situation reflects that March was a mistake.

However, I am a bit uneasy about markets at the moment in the sense that we do not yet have the pandemic firmly under control in significant parts of the world including significant parts of the US. While I would say that stimulus that's being put into the pipeline and the economic outlook could justify roughly current market valuations. The balance of risks to markets at the moment in my view is that we get some bad virus news out of the US, which may then rattle markets again for a while.

With the risk-reward balance I think the markets have stretched it quite a bit at the moment.

PRESENER: What about the concerns of a second spike in Germany as well, because we have seen that R number increase this week. How are you factoring in the potential for a second spike into your estimates?

DR SCHMEIDING: Economists are not virologists. We can't really predict that, but my impression is that what we are having now is isolated hotspots in a number of areas. You can pinpoint them. We know much better than we did in late February early March about how to react to those things.