The pick-up in six-month G7 real narrow money growth since February suggests a revival in global industrial momentum from the late summer, barring “shocks”. This should be led by Japan and the US with the Eurozone and some emerging economies lagging.

Today’s Japanese industrial output and PMI reports fit the story. Output rose by 3.9% in June and manufacturers plan further increases of 2.2% and 2.0% respectively in July and August despite power constraints. The implied August level of manufacturing production is only 1.3% below the February peak before the 15 March earthquake / tsunami. The key PMI new orders index, meanwhile, moved convincingly into expansionary territory (i.e. above 50) in July.

Global PMI results for July will be mixed – the flash Eurozone survey weakened significantly – but this is consistent with the monetary forecast that momentum should be stabilising at a low level, with clear evidence of a pick-up scheduled to emerge only at the end of the summer, reflecting the lag of six months or so between real money and activity.

EU Commission business and consumer survey results for July confirm that the Eurozone economy is stalling, as signalled by earlier monetary weakness. The “economic sentiment indicator” is a weighted average of confidence measures covering industry, services, retail trade, construction and consumers, with 100 representing the long-run mean (i.e. over 1990-2010). The Eurozone-wide indicator fell for the fifth consecutive month in July, reaching its lowest level since August.

The monthly decline in July was the largest since February 2009 and reflected weakness across economies, with Germany and Italy registering notable falls. The impression of recent Spanish resilience in the chart is misleading because of a methodological change in May that has raised the level of the indicator – otherwise it, too, would probably be at a new low for the year. The UK measure also softened last month but is little changed since January versus a big Eurozone decline.

Gathering economic weakness should head off further ECB tightening, thereby promoting much-needed euro depreciation.

Eurozone real narrow money, M1, contracted by 0.9% (not annualised) in the six months to June – slightly smaller than a 1.4% fall between November and May but still signalling a grim economic outlook:


The country deposit breakdown continues to show contraction in the core as well as the periphery, suggesting that the recent two-speed economy will soon give way to generalised economic weakness:


Fortunately, declining Eurozone real narrow money has been offset by strength in the US and Japan, resulting in G7 six-month growth rising further in June, reaching its highest level since 2009:


The pick-up in G7 real narrow money is the basis for the forecast here of a revival in global industrial momentum during the second half, suggesting imminent stabilisation / improvement in manufacturing purchasing managers’ surveys. Equity analysts’ earnings revisions correlate with G7 PMI new orders and were slightly less negative in July, consistent with the story:

UK GDP is provisionally estimated to have risen by 0.2% last quarter and by only 0.7% over the last year. These figures understate the economy’s underlying progress because of a big fall in North Sea production and special factors that depressed the second-quarter outturn – the royal wedding bank holiday, disruption due to the Japanese earthquake / tsunami and Olympic ticket sales that will not be recorded in the national accounts until the third quarter of 2012. Without these effects, GDP would have risen by 0.8% last quarter and by 1.6% over the last year. (These numbers are derived by summing the increase in GDP excluding oil and gas production – 0.3% on the quarter and 1.1% on the year – and the official estimate that special events subtracted a net 0.5% from the level of output in the second quarter.)

1.6% annual growth is disappointing but may be in line with the expansion of productive potential, with the trend rate of increase of productivity depressed by an overinflated public sector and resource misallocation due to the credit bubble. This interpretation is consistent with the solid 1.1% rise in employment over the last year and business survey evidence indicating a rise in capacity utilisation.

Policy-makers should aim for faster growth than potential to absorb remaining economic slack, although the negative “output gap” is probably much smaller than widely assumed. Rather than a less contractionary fiscal Plan B, however, the economy needs a Plan A to cut inflation, which has been a much bigger drag on growth via its depressing impact on real money and income expansion. More QE would work in the opposite direction by tanking sterling and causing another surge in import prices.

The chart compares the recent path of GDP excluding oil and gas production with previous recessions / recoveries, with the peak quarter of output rebased to 100 in each case. The current cycle continues to resemble the late 1970s / early 1980s – the peak to trough fall in non-oil GDP was 6.3% in 1979-81 versus 6.2% in 2008-09, while the level of output in the second quarter of 2011 was slightly higher than at the comparable point of the early 1980s recovery (even before adjusting for distortions). Unemployment of 7.7% now compares with nearly 11% then. Economic conditions remain difficult but gloom about recent performance and prospects is overdone.

The Eurozone rescue deal agreed last week marks another step on the road towards fiscal burden-sharing and is likely to calm markets, at least temporarily. The absence of any expansion of the European Financial Stability Facility (EFSF), however, should result in Spanish and Italian yields retaining a significant risk premium. The Eurozone seems to be progressing slowly and haltingly towards a full fiscal union, with periodic bouts of market turbulence forcing politicians to accept incremental reforms.

• A fiscally-unified Eurozone would have no sustainability issues. General government net debt is projected by the OECD to be 60% of GDP at the end of 2011 compared with 62% in the UK, 75% in the US and 128% in Japan – see first chart. The 2011 fiscal deficit is forecast at 4.2% of GDP versus 8.7% in the UK, 8.9% in Japan and 10.1% in the US.

• Importantly, this relatively respectable fiscal position does not depend solely on Germany. The rest of the Eurozone is projected to run a deficit of 5.0% in 2011, with net debt ending the year at 64%.

• Last week’s deal conceded further ground on the principle of fiscal burden-sharing, by easing significantly the terms of official lending to the bail-out countries and allowing the EFSF to provide pre-emptive credit lines to countries facing funding difficulties and buy bonds in secondary markets.

• A key weakness of the deal, however, was the absence of any expansion of the EFSF, which has insufficient resources credibly to protect both Spain and Italy from contagion. Yields in the two countries, therefore, may continue to incorporate a sizeable risk premium, with spreads over Germany failing to revert to levels prevailing before the recent crisis. The deal, meanwhile, needs to gain approval in all 17 euro area member states.

• A full resolution is likely to require the transformation of the EFSF, and its proposed successor the European Stability Mechanism, into a “European monetary fund”, able to issue unlimited quantities of “eurobonds” – for which member states are jointly and severally liable – to raise funds for on-lending at non-penal rates to countries following an agreed fiscal programme. A further crisis may be necessary to overcome political resistance to such a fundamental reform (including in potential borrowing countries that would lose their remaining fiscal autonomy).

• Renewed market turbulence could be triggered by disappointing economic performance during the second half of 2011, as suggested by monetary trends, resulting in fiscal slippage relative to current plans. Monetary weakness, however, has recently extended from peripheral to core economies, including Germany – a generalised economic slowdown could push the ECB to the sidelines and allow the euro to depreciate, offering relief to the periphery.

• A debt-weighted average of Eurozone yields has fluctuated in a relatively narrow range since early 2011, reflecting a negative correlation of peripheral spreads and the level of yields in Germany and other core countries – second chart. This may continue, with a near-term modest narrowing of spreads offset by a rise in core yields in response to reduced “safe-haven” demand and in recognition of fiscal dilution.