Credit Suisse, European Economics, Aug 19, 2013. "Investing in the future".

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European Economics

Investing in the futureThe euro area has reached an inflection point. Euro area Q2 GDP grew by0.3%, after six quarters of recession, driven by a solid pick-up in domesticdemand (private consumption in particular) in the core and an attenuation of the

domestic demand recession in peripheral Europe. For once, the euro area wasnot a drag on global activity as also suggested by some moderation in net

external trade dynamics.

Investors focus may now begin turning to how the euro area could surpriseto the upside. That might be premature and our central scenario is one of

muted recovery in the coming quarters but optimists should look into investmentdynamics, in our view.

Investment, we believe, could provide a key source of upside risk. There areseveral reasons for this:

Investment is a high beta element of the business cycle, and depends onbusinesses expectations of future economic activity. If these start to surprise to

the upside, also thanks to the reduction of political and policy uncertainty, so

could investment.

Investment as a percent of GDP has fallen markedly. Based on 2013 forecasts

from the European Commission, the 2008-2013 decline in investment as apercent of GDP will be higher in the euro area than in the UK or the US.

Net investment is at around 2% of GDP, compared with 6.7% in the pre-08period. This suggests very modest increases in the capital stock.

Profit growth rates appear to be on the verge of recovering, and investment

growth has been weaker than profit growth in the past years.

Non-financial corporates In the euro area are in financial surplus, meaning thatinvestment projects could be funded internally. In addition, the external funding

cost has fallen. This could provide an incentive to undertake the marginal

investment project.

As usual, there are also potential downsides. Corporate indebtedness,

particularly in certain euro area countries is high, so companies may want to usetheir financial surplus to pay down debt rather than to invest. In addition, after

several consecutive negative shocks to expectations, firms may remain slow toencompass better news into their decision-making process. A fragile confidence

backdrop that could be upset next year by the negotiations on the banking union credit and product & labour market rigidities could also slow down the

reallocation of resources and consequently the recovery in investment

expenditure.

These are key concerns, and mean that we envision a steady recovery in

investment and more generally in activity, rather than a rapid one. Ourcurrent forecasts for investment are -2.9%yy in 2013, and 3.7%yy in 2014

consistent with our GDP growth expectations of -0.5% this year and 1.2% next.

Research Analysts

Christel Aranda-Hassel

+44 20 7888 1383

[email protected]

Steven Bryce

+44 20 7883 7360

[email protected]

Violante Di Canossa

+44 20 7883 4192

[email protected]

Neville Hill

+44 20 7888 1334

[email protected]

Axel Lang

+44 20 7883 3738

[email protected]

Giovanni Zanni

+44 20 7888 6827

[email protected]

19 August 2013

Economics Research

http://www.credit-suisse.com/researchandanalytics


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19 August 2013

European Economics 2

Investing in the Future

Euro area GDP posted a slight upside surprise in Q2, growing 0.3%qq after falling a

cumulative 1.5% between Q3 2011 and Q1 2013. The country breakdown was also positive.

While the core countries continued to be the main growth engine, as might be expected, the

peripheral economies showed that they have reached a turning point. We estimate that

Greek GDP was flat on the quarter, ending 13 consecutive quarters of contraction, and

Portugal posted a quarter-on-quarter growth reading of 1.1%. The larger peripheral

economies while still contracting, posted smaller contractions than in previous quarters.

Overall, we believe that this is consistent with the story in higher frequency data and survey

indicators, namely that the euro area has reached a turning point in the business cycle, and

is now on the threshold of we believe sustained expansion.

As such, investor sentiment is now shifting from the question, when will the euro

area economy stop contracting? to how quickly could the euro area economy

expand? Our central view is that the pace of recovery will be modest. Business and

consumer confidence has been severely hit, and will take time to return. In addition,

deleveraging dynamics and structural changes could present a headwind to growth in the

medium term. Nonetheless, we do not think all risks are on the downside and we believe

there is a chance that euro area could also surprise on the upside. If we consider where thesource of this upside surprise could be, investment stands out as a key candidate.

Exhibit 1: EA GDP Exhibit 2: EA country dispersion, Q2 13

Index, Q1 2008 = 100 Growth qq%

94

95

96

97

98

99

100

08 09 10 11 12 13

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

1.2

IT NL ES GR EA17 FR BD PT Source: Credit Suisse, Eurostat Source: Credit Suisse, Eurostat

Compared to the other components of GDP, investment appears to be the likely source of

any upside risk. On the external front, further contractions in imports (which would act to

support GDP) are probably consistent with poor domestic demand not expansion. The

behavior of exports in the medium term is more dependent on the international businesscycle than other factors. While we believe that government spending will stop as a

significant headwind to growth going forward, the scope for this to begin positively

contributing to GDP is limited. Household consumption could be a source of upside

surprise in some countries. However, the scope for upside risk to euro area consumption

in the near term is limited. Several of the peripheral economies are likely to face

substantial headwinds to consumption in the near term. While part of the rebalancing

process would be for Germany to expand its level of consumption which could outweigh

these headwinds from the periphery there is limited evidence that such large-scale

rebalancing is under way.

Steven Bryce

+44 20 7883 7360

[email protected]

Giovanni Zanni

+44 20 7888 6827

[email protected]


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19 August 2013


This leaves investment as a potential source of upside risk, and we do see reasons

to be positive on the investment outlook. Exhibit 3 shows the difference in investment

as a percent of GDP between 2008 and 2013 (using EC forecasts for the full 2013 year).

The fall in investment as a percent of GDP in the euro area is forecast to be larger than in

the US and the UK (although in absolute level terms, the UK has been weak), and the fall

in some of the peripheral economies has been particularly large.

Exhibit 3: Fall in investment Exhibit 4: In levels termsAs percent of GDP, 2008 to 2013, EC forecast 2008 = 100, US is private GFCF

0

1

2

3

4

5

ES EA 17 IT UK US FR BD

Spanish fall was 11.1%

70

75

80

85

90

95

100

08 09 10 11 12 13

US

UK

EA17

Source: Credit Suisse, AMECO database Source: Credit Suisse, national statistics offices

To be sure, some of these declines in investment in the peripheral economies are

likely to be permanent. Spain and Ireland in particular experienced unsustainable

construction bubbles, and so the level of investment as a percent of GDP in these

economies is likely to be persistently lower in the future.

Nonetheless, there is an argument that some of this decline could be filled by the

German construction sectorand more in general by stronger overall investments in that

country, stimulated by exceptionally low nominal and even more real interest rates.

For the euro area in aggregate, construction investment as a share of GDP appears

low, even when considering long-term series (Exhibit 5) so it is unlikely to drag on

an investment rebound. In addition capacity utilisation, while at a relatively low level, has

begun to increase. This should therefore be a decreasing headwind to investment

expansion in coming quarters.

Exhibit 5: Investment ratio as % GDP Exhibit 6: Capacity utilization rate manufacturing

6

7

8

9

10

11

12

13

85 87 89 91 93 95 97 99 01 03 05 07 09 11 13

construction

non-construction

69

71

73

75

77

79

81

83

85

85 87 89 91 93 95 97 99 01 03 05 07 09 11 13

Historical

Whole sampleseries average

Source: Credit Suisse, AMECO, Eurostat Source: Credit Suisse, European Commission


4/10

19 August 2013


The charts in Exhibit 7 and Exhibit 8 also suggest that investment has seriously undershot

in the current cycle.

Net investment in the euro area is at historical lows, around 2% compared to a 6.7%

historical average. This suggests that the capital stock in the euro area is hardly growing.

An upward revision of firms expectations for output could stimulate investment as

businessmen seek to ensure that they can reach expected new levels of demand in the

future. Exhibit 8 shows annual gross investment growth in the euro area over the past 50years. It demonstrates that growth is now at long-term lows.

Exhibit 7: Net investment Exhibit 8: Gross investment growth

% GDP Growth yy%, 5y moving average, euro area 12

0

1

2

3

4

5

6

7

8

1995 1999 2003 2007 2011 2015

Net capital formation as% GDP historicalNet capital formation as

% GDP forecastAverage 1995 to 2007

-4

-2

0

2

4

6

8

1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Source: Credit Suisse, AMECO Source: Credit Suisse, AMECO

The cyclical nature of investment also means that it stands out as a candidate for an

upside surprise to GDP. As Exhibit 9 shows, gross fixed capital formation has a beta withGDP, that is much higher than household consumption. In other words, as economic

activity picks up, there is a risk that investment rises quickly.

Exhibit 9: Beta of expenditure component with GDP Exhibit 10: Change in past cycle

%

0.0

0.5

1.0

1.5

2.0

2.5

3.0

Gment cons HH cons GFCF Imp Exp

international correlationof the business cycle

-17

-12

-7

-2

3

GDP HH cons Gment cons GFCF

Q1 2008 - Q2 2009

Q2 2009 to Q3 2011

Q3 2011 to Q1 2013

Source: Credit Suisse, Eurostat Source: Credit Suisse, Eurostat


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19 August 2013


This relationship with GDP has been broadly on the downside, rather than the

upside over the past five years. Exhibit 10 shows the performance of various

components of GDP during the three stages of the post-2008 economic environment in the

euro area. Stage 1 (Q1 2008 to Q2 2009) is the decline in GDP that followed the financial

crisis. Stage 2 (Q2 2009 to Q3 2011) is the upswing that followed. Stage 3 (Q3 2011 to Q1

2013) is the downswing associated with the euro area sovereign crisis.

This chart shows that while investment has performed very negatively in the downswingelements of the cycle, it was actually rather weak during the upswing. In fact, GDP was

broadly supported by net trade during the Q2 2009 to Q3 2011 period, rather than

investment. If this behavior were to continue it would argue for a weaker profile for

investment.

Exhibit 11 and Exhibit 12 show simulations for profiles of future investment based

on historical experience. These profiles show how year-on-year investment growth

would look if investment followed the same approximate profile for growth following the

trough in previous cycles. The dotted blue line in Exhibit 11 assumes instead that

investment will return to its peak percentage GDP over the same time frame as occurred

in the 2002 cycle (that is, sixteen quarters). This is much stronger than the other

simulations, and would probably be consistent with a sharp rebound in business

confidence.

Exhibit 11: Simulation based on previous EA Exhibit 12: and US experience

Private US GFCF

-15

-10

-5

0

5

10

96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16

Historical

2002 recovery

2010 recovery

Based on GFCG % GDP 2002

recovery1980's recovery

-15

-10

-5

0

5

10

96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16

Historical

US 2003 recovery

US 2010 recovery

Source: Credit Suisse, Eurostat Source: Credit Suisse, Eurostat

While we think that gross fixed capital formation could provide some upside, we see

less the case for an inventory-led cyclical rebound. As Exhibit 13 and Exhibit 14 show,

the inventory cycle has not reached the level of destocking that it did during 2008-2009. Assuch, there is unlikely to be much rebound from the companys additional inventory

demand. This provides some support for the view that the next phase of recovery in the

euro area could be somewhat modest.


6/10

19 August 2013


Exhibit 13: Inventories from the PMIs Exhibit 14: Inventories from national accountsStocks of finished goods Four month sum, bn, estimated from the national accounts

40

42

44

46

48

50

52

98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

Stocks of finishedgoods

1998 to presentaverage

-40

-20

0

20

40

60

80

96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 Source: Credit Suisse, Markit Source: Credit Suisse, Eurostat

The behavior of investment surveys and profits are consistent with some

improvement in the investment outlook, but do not yet suggest significant short-

term expansion. Exhibit 15 shows the relationship of the euro area economic sentiment

indicator with investment. The sentiment indicator is now increasing, but is still consistent

with negative rates of investment growth at least in year-on-year terms. Exhibit 16 shows

the relationship between profit growth and investment for non-financial corporates in the

euro area, along with an estimate for Q2 this year based on the GDP growth figure.

Again, the profit rate is still consistent with a fall in investment. However, profit

growth is on the verge of positive growth. In addition, investment has fallen much more

sharply than profits in the latest downturn. This could be due to the extreme shock to

business confidence. As confidence returns, in line with market and survey evidence, it is

possible that investment could grow at a faster rate to fill this gap.

Exhibit 15: Investment surveys Exhibit 16: Profits and investment

Non-financial corporates, blue square is Q2 estimate

70

80

90

100

110

-15

-10

-5

0

5

10

96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

EA17 GFCF, yy%, l.h.s.

EA17 Economic Sentiment

Indicator, r.h.s.

-20

-15

-10

-5

0

5

10

00 01 02 03 04 05 06 07 08 09 10 11 12 13

Profit growth yy%

Nominal GFCF

growth yy%

Source: Credit Suisse, European Commission, Eurostat Source: Credit Suisse, ECB


7/10

19 August 2013


The remaining key element is funding costs and credit availability.Credit standards

have stopped tightening (Exhibit 17), meaning again that a headwind to growth in

investment at the aggregate level has been reduced.

Significant cross-country dispersion, especially in the case of SMEs, remains a key issue.

It can be argued that some form of credit crunch is at play for small and medium-sized

companies in the euro area periphery (Exhibit 18), although recent measures, such as the

payment of arrears by governments and support to lending via the EIB and other special

schemes should ease credit conditions for those companies as well in the coming months.

Exhibit 17: ECB bank lending survey Exhibit 18: Dispersion of financial conditions

Standards applied by banks Weighted percentage of responses

-20

-10

0

10

20

30

40

50

60

70

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Credit standards past three months

Creedit standards next three months

0

10

20

30

40

50

60

EA GER FRA ITA SPA IRE POR

did not apply due to expectationof rejectionreceived only limited amount

costs too high

application rejected

Source: Credit Suisse, ECB Source: Credit Suisse, ECB

Nonetheless, for those firms that do have access to credit the terms can be favourable. In

the core economies funding costs are at low levels, as suggested by Exhibit 20. Such low

rates should encourage firms to undertake marginal investment projects, as the required

rate of return for these projects to break even is lower than it would otherwise be. In the

periphery, certain rates are punitive, particularly for small firms. However, as the

macroeconomic environment improves and government bond yields fall, this may helplower funding costs for corporates. Indeed, the Credit Suisse LEI index suggests that

yields on the most liquid bonds of industrial companies and utilities in the periphery have

fallen in the past 18 months. Again, this could support investment activity in the periphery.

Exhibit 19: Government bond rates Exhibit 20: Lending rates

5 year, government bond rates Interest rate on small, short-term new loans to non-financial corporates

0

1

2

3

4

5

6

7

00 01 02 03 04 05 06 07 08 09 10 11 12 13

Core

Periphery

3

4

5

6

7

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Periphery

Core

Source: Credit Suisse, Thomson Reuters Datastream Source: Credit Suisse, ECB


8/10

19 August 2013


Finally, firms (in aggregate) may not need to turn to external financing to fund

investment for now. Exhibit 21 shows that euro area non-financial corporates are now in

financial surplus, meaning that they could fund projects internally. Some of this surplus

may be due to a precautionary motive, and so it is possible that firms would be willing to

run a lower net surplus as economic sentiment and confidence improves. However, as

Exhibit 22 shows, non-financial corporates, particularly in certain peripheral economies,

are highly indebted. These firms may wish to use their financial surplus to run down debt,

not to spend. Nonetheless other countries, particularly Germany, could be in a position toinvest further. The German non-financial corporate financial account surplus is 3% of GDP.

Overall, we see a compelling case for a rebound in investment, especially in core

countries (and in Germany in particular), but also for the euro area aggregate as a

whole. A rebound in investment might be the best chance for GDP to surprise on

the upside, although given the points we highlighted below evidence is more

consistent with expectations of a modest acceleration in investment and, more

generally, in GDP growth.

Exhibit 21: Net lending/borrowing Exhibit 22: Distribution of debt to GDP

Non-financial corporates % GDP Non-financial corporates

-4

-3

-2

-1

0

1

2

99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

0

50

100

150

200

GR BD IT NL EA17 FR ES PT IR Source: Credit Suisse, ECB Source: Credit Suisse, ECB, Eurostat


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Credit Suisse, European Economics, Aug 19, 2013. "Investing in the future".

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Transcript of Credit Suisse, European Economics, Aug 19, 2013. "Investing in the future".