Reverting Below the Mean

Topics - Macroeconomics

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Reverting Below the Mean

This time last year, the European economy was flying high. It had experienced two years of strong growth and many indicators were near cyclical highs. Most analysts predicted continued expansion. A few economists dissented from the consensus, arguing that European growth would revert to its mean. For the first two quarters it looked like they were right: many of the European data sets, such as the Purchasing Managers Indexes, GDP, industrial production, and retail sales, peaked around the end of 2017. But instead of stabilizing, the numbers kept falling. By the end of year, GDP growth had fallen below estimates of potential growth, which surprised all but the most diehard Euro-trashers. 1 1 Close Reversion beyond the mean isn’t discussed enough in quant circles. Now two of the biggest economies in Europe – Italy and Germany – are at or near recession. 2 2 Close Italy entered a technical recession (two quarters of negative growth) in Q4 of 2018. Italian Q3 2018 GDP was -0.1% QoQ and Q4 2018 GDP was -0.2% QoQ. Germany will see the release of its Q4 2018 GDP data on February 14, 2019, but there is also a chance the country has entered a technical recession as its Q3 2018 GDP was -0.2% QoQ. Sources: ISTAT, German Federal Statistical Office.

Normally sharp slowdowns come after some sort of shock or credit tightening. This does not seem to be the case here. The ECB has kept rates negative, and even though new QE purchases are ending, its balance sheet remains at record size. Credit spreads are still very tight. In the absence of obvious drivers, market participants have all but asked economists to get creative in coming up with explanations. And economists have been more than up to the task. One theory floated during the summer was that German automakers were slowing production to comply with emissions standards. 3 3 Close They had worked so hard to avoid the old ones, so it is even harder to comply with the new ones. This certainly hurt production numbers, but the slowdown has carried on for too long to be explained by this alone. The drop in industrial production has extended well beyond autos into almost every sector in Germany.

Another explanation was that the water levels in the Rhine river had gotten so low that ships had trouble getting through. 4 4 Close No one was concerned about the Rhône river. It’s always the Rhine. So unfair. This prevented the delivery of goods within Europe. While it does seem as though parts of the economy experienced some riverside blues, it’s unlikely that the whole European economy was stuck waiting for the waters to rise. By the fourth quarter, water levels had risen to the point where freight ships could go through, but economic activity did not recover.

Politics have also weighed on European economic activity. Elections in Italy led to a selloff in its bonds followed by conflict with the EU over its budget. The “yellow vest” protests in France have hurt tourism, prevented people from getting to work and have contributed to a meaningful fall in consumer confidence. These have probably dented GDP, but politics does not present the kind of existential threat that we saw in 2012. There has been little talk of a break-up of the European Union, and assets aren’t pricing a real risk of that happening. This risk could come back, but it doesn’t seem like a current driver.

The European economy has always been very reactive to the industrial cycle and many of the countries are big manufacturers. Some have attributed Europe’s struggles with a fall in demand for European goods from China, causing a downturn in the industrial cycle. Trade was a net drag on euro-area GDP in Q3 2018, but exports to China held up well through the first three quarters of the year. 5 5 Close Source: Eurostat. They fell sharply late in the fourth quarter, so it is something to watch going forward.

So it would seem like we are going to argue that all of these causes are wrong and there is some other big factor that has been ignored. Quite the opposite. 6 6 Close The strawman strikes back! He was overdue for a win. We think it is probably all of those things together. Since 2009, fiscal deficits in Europe have fallen, largely driven by Germany. During and after the sovereign crisis, the private sector also became risk averse, and banks were unwilling to lend. Private sector savings rates rose and stayed very high. This retrenchment in both parts of the economy led to weak growth and a large current account surplus. 7 7 Close It is impossible for all sectors to have a surplus in a closed economy. If a country is running surpluses in all parts of the economy, it must have a surplus with the rest of the world. Things have to balance. Then after a few years of very loose credit, banks started to lend again, consumers spent more and business investment rose. Savings fell and activity took off, but as public deficits continued to fall, the economy was vulnerable to any change in sentiment. A drop in river water levels or a political protest could dent the still fragile private sector. In 2018, we saw private sector surpluses steadying while government deficits shrank again. A small change in sentiment weighed on the economy.

This may actually leave Europe in a better position than much of the rest of the world. In contrast with many countries where deficits are already larger, some European governments have room for fiscal stimulus. 8 8 Close The U.S., for example, will probably face fiscal tightening in the next two years. The political tide in the EU is moving toward looser fiscal policy. Macron reacted to the protests in France by offering more fiscal spending. Even Germany could increase government spending after last year’s election prevented them from making meaningful budget changes. Sentiment could improve in the private sector. Employment has held up better than most of the other data, and with inflation back below target the ECB may take symbolic, if not substantive, easing measures. At the very least, the ECB can hold off on raising rates.

There are some risks out there too. A more severe slowdown in China could hurt trade. Political problems could resurface. There is also this thing going on in the U.K., which could severely hurt growth if it is not resolved satisfactorily. 9 9 Close Not going to say Brexit. Maybe in the footnote, but not in the text. If the temporary factors were causing the slowdown, data should improve quickly in the first quarter of 2019. It will be worrying if it doesn’t. Finally, because of demographics and other structural reasons, potential growth in the EU is not particularly high. What this means is that barring some big exogenous event, Europe will probably mean revert again – this time back up to its potential growth. 10 10 Close Not going to say hard Brexit, which could be considered a big exogenous event. Everybody’s tired of hearing about Brexit. Just keep in mind that isn’t very high.

What We Are Watching 

U.S. GDP, Retail Sales, Durable Goods (TBD) Because of the recently-concluded government shutdown, a number of U.S. economic releases were not published at their usual times. This included several high-profile data points, particularly 4th quarter GDP growth, December retail sales, and December durable goods orders. Now that the government is up and running again, statistical agencies impacted by the shutdown have started to work through the backlog of data. As of this writing, publication dates for the key series mentioned above have not yet been announced, but these figures could well be released at some point next week. Survey data (mostly published by the private sector) has pointed towards some loss of momentum in the U.S. economy over the last couple of months, but it has been difficult to determine the extent of the slowdown. Market participants and policymakers will be paying close attention to these delayed data releases as they seek to assess the balance of risks around the U.S. growth outlook.

Australia Central Bank Meeting (Tuesday) After remaining on hold throughout 2017 and 2018, the Reserve Bank of Australia (RBA) will meet for the first time in 2019 this week. Recent international and domestic economic data point to a mixed picture. Recent inflation data was slightly higher than expected, although still below the central bank’s 2-3% inflation target. Iron ore, a meaningful export for Australia, has seen prices rise rapidly since the beginning of the year, and there have been some signs of stabilization in Chinese growth as well, a positive sign given the country’s importance as a destination for Australian exports. However, worsening business confidence and a slowing housing market remain concerning for the RBA. Given slower growth concerns and risks to the external environment, the market is currently pricing some probability of a rate cut this year. The RBA is expected to remain on hold at this meeting, but there is some chance the statement shifts to a more dovish tone.

Bank of England The Bank of England will announce its policy rate decision on February 7 amid considerable uncertainty around Brexit negotiations. Market expectations for Thursday’s meeting imply no action by the Monetary Policy Committee, with around half of a 25bps hike priced over the next twelve months. Governor Carney’s recent remarks at Davos reiterated that the outlook for monetary policy depends crucially on the outcome of Brexit negotiations. The central bank has conducted stress tests on the financial sector considering the hardest Brexit scenario. But with that noted, the BoE maintains a bias toward gradual and limited tightening of policy, conditioned on a smooth adjustment of the economy to the average of a range of possible future trading relationships with the EU. The conditionally hawkish bias is based on the strength of the labor market and rising wage growth that supports their outlook for firm domestic inflationary pressures.

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