Rates were cut again after the Eurozone recovery came to a halt in the second quarter. GDP growth amounted to exactly 0.0% compared to the previous quarter, while gross fixed capital formation dropped 0.3%. The German economy shrank, somewhat surprisingly underperforming France, and the third-largest economy, Italy, fell back into recession. The economic impact of the Ukraine crisis has been much larger than expected, primarily due to its confidence-damaging nature. As a consequence, bond yields have come down to amazingly low levels: German 10-year yields are currently below 1.0%, and Italian yields are currently 2.3%. For the privilege of lending up to three years’ money to governments such as Germany, investors now pay a premium.
The continuing relentless bull run on bond markets was the striking development this August. Aside from the weakening of the European economies, the downtrend in actual inflation and the growing fears of Japanese-style stagnation that can all explain these low yields, they are also a reflection of the likelihood of further aggressiveness by the European Central Bank. ‘Don’t fight the ECB’ could be an appropriate motto. We consider the likelihood of a new European recession to be small. We expect a stronger third quarter for a number of reasons and continue to expect an ongoing recovery of the Eurozone economy. The main risk to this scenario would in our opinion be a severe further escalation of the tensions between the West and Russia.
Ukraine crisis ending in a frozen conflict?
Evidence is mounting that the German economy is being hit by the ongoing jitters over the Ukraine crisis. German businesses are very cautious about making new investments. Gross fixed capital formation declined 2.3% in the second quarter. But the Ukrainian crisis is now showing signs of becoming less heated. Russia has made it clear that it won’t allow a destruction of the pro-Russian separatist region in Eastern Ukraine by sending sufficient troops and weaponry. On the other hand it has demonstrated a cautious attitude because the change in the military balance has not resulted in an offensive to take cities such as Odessa or Kiev. The logic of the situation suggests a stalemate, a so called ‘frozen conflict’. The Eastern Ukrainian provinces including a land bridge to recently annexed Crimea will remain firmly under Russian control, but hostilities will end, paving the way for what will most likely be long-winded negotiations. The current, rather weak sanctions will remain in place, with limited economic impact. Under these circumstances business confidence in Europe could rebound.
Of course, the current de-escalation in Ukraine could in the end turn out to be a “judo-inspired trick” by Russian President Vladimir Putin, who has a black belt in the sport. During the winter, when Europe is much more vulnerable to an immediate cut-off of Russian gas, tensions could rise again, though it should be kept in mind that countries such as Germany are already in a position to withstand a five-month boycott. The ultimate aims of the Russian leadership remain unclear. It could easily decide to stir up ethnic tensions in the Baltic region. Possibly we have only seen a couple of moves in what could turn out to be a very long chess game. We cannot be sure. But for the time being, our baseline scenario is a de-escalation of the conflict.