Does a New Eurozone Recession Threaten U.S. Growth?

It’s a perfect score for Germany’s economic reports so far this week—perfectly negative. In two days we’ve seen two macro updates for Europe’s biggest economy and in both cases the numbers were deeply disappointing. Yesterday we learned that new manufacturing orders suffered a substantially larger-than-expected decline in August, followed by today’s news that industrial output plunged 4% during that month. On a year-over-year basis, industrial activity in Germany has crumbled by 3%. It’s been clear for the past month or so that the country’s expansion was slowing, but the latest figures suggest that the deceleration is much worse than assumed.

The surprisingly hefty degree of deterioration comes at a time when Europe can hardly afford a new phase of macro trouble at its core. Eurozone GDP was flat in Q2 for the quarter-over-quarter comparison, according to Eurostat, and the recent negative momentum via the Bank of Italy’s Euro-coin projections leaves little room for optimism about the near-term future.

The latest numbers from Europe’s so-called growth engine certainly don’t offer any reason to think otherwise these days. Until recently, Germany’s growth has been modest but reliable, not to mention a critical source of support that’s kept the Eurozone inching forward, if only on the margins. But it now looks like Germany and the rest of the Europe is in recession. Ok, so what does that mean for the US economy?

It would be surprising if we don’t see some blowback in America. The European Union, after all, is a major trading partner with the US. There’s still a reasonable chance the US will continue to grow regardless, although the growth will probably be lower because of Europe’s recession. It may be hard to see the difference, of course, because we’ll never know what the US would have done if Germany and the Eurozone sidestepped a downturn. In any case, it would be surprising—impossible, really—if the latest round of contraction overseas doesn’t take a bite out of US economic output.

The good news is that the recent numbers for the US look encouraging, which offers a degree of insulation. Friday’s payrolls report in particular suggests that the macro trend is still humming along at a moderate pace. My big-picture reviewof the major indicators from a few weeks ago also shows a high degree of positive bias in the numbers, which suggests that economic momentum has been fairly strong lately. But with Europe now at the tipping point, there’s more uncertainty about the US outlook.

It’s worth pointing out that a new recession for Europe at this stage threatens to be particularly nasty because deflation risk is considerably higher this time. Indeed, consumer price inflation for the Eurozone is now a mere 0.3% on a year-over-year basis. (By comparison, US consumer inflation is advancing at a 1.7% annual pace.) At a time when recession risk is rising, the risk of outright deflation poses a considerable obstacle because of all the macro consequences that come with that condition. At the very least, lowflation at this point makes escape from recession that much tougher for Europe.

A potential antidote to Europe’s ills, or at least one that has a reasonable chance of minimizing the damage, would be the launch of an aggressive new round of monetary stimulus by the European Central Bank (ECB). Nothing less than a shock-and-awe campaign is required at this stage, however. That’s unlikely. Sure, the ECB continues to tinker around with half-measures and modest efforts at juicing growth, but so far those efforts have been ineffective. Indeed, the fact that the Europe appears to be slipping back into a contractionary phase is irrefutable evidence that the ECB’s policies so far have been a dismal failure. By comparison, the Federal Reserve’s quantitative-easing programs over the last few years present a considerably more encouraging record.

The great irony here is that Germany’s push to keep the ECB from doing more have apparently succeeded—a success that’s now coming back to haunt Merkel and company, and all of Europe. You shall reap what you sow.

As for the US, the incoming data will be more important than ever for monitoring the negative effects thrown off by Europe’s latest troubles. The next major release: Thursday’s weekly update on jobless claims. For the moment, the crowd’s expecting new filings for unemployment benefits to remain under 300,000 (seasonally adjusted) and therefore stick close to a 14-year low. Next week will bring additional perspective via retail sales (Oct. 15), industrial production (Oct. 16), and housing starts (Oct. 17). Even then, it’ll take a month or two to judge the effects on US data in terms of measuring the ill effects of Europe’s macro slide, which is still in its early stages.

The US economy, in short, is about to undergo a new phase of stress testing. For the moment, it’s still reasonable to expect that the planet’s largest economy will survive with its growth intact, albeit somewhat dented. The assumption here is that macro momentum in these United States is sufficiently strong to weather any turbulence from abroad. But that’s just a guess. Ultimately, the incoming numbers will tell the story, for good or ill. Meantime, the case for expecting a relatively early start of Fed tightening just flew out the window.

This piece is cross-posted from The Capital Spectator with permission.