Always on the look-out for a silver-lining, the world’s commission-taking asset managers are flooding into the new cleanest dirty shirt of European stocks (the more beaten-down, the better) – apparently on the basis of the exuberance in surging PMIs. Aside from the fact Draghihimselfalreadypouredcold–wateronpeople’sbeliefinthestrengthoftheEuropeanrecoverylastweek, and ournotethisweekendonthe ‘roughness‘ ofPMIsurvey "soft" data, investors remain unmoved and momentum has taken over now. However, as Goldman explains some of the optimism on the basis of recent manufacturing PMIs may not square with evidence of a structural break in the link between the PMIs and growth. While a readingof 50 mayinpre-crisisdayshaveindicatedpositivegrowthontheperiphery, ittodaymayonlyindicateflat (orevennegative) growth, as the external financing constraint prevents better sentiment from translating into activity.
PriortotheEurozonecrisis, “neutral” PMIreadingsof 50 tendedtocoincidewithpositiveGDPgrowthontheperiphery, so that this threshold could perhaps better be thought of as representing trend (or potential) growth. Prior to the Euro zone crisis, external financing was plentiful for the Euro periphery, which is no longer the case. As a result, trend growth on the periphery is likely to have fallen, so that whereas a PMI reading of 50 used to correspond to positive growth itmightnowcorrespondtotrendgrowthofzeroorevennegative.
TheseresultssuggestthatthesignalfrommanufacturingPMIstogrowthhasdeterioratedintheEurozone, withbettersentimentnottranslatingthewayitoncedidintoactivity. This deterioration in the signal from PMIs to growth is most pronounced for periphery countries (Italy, Spain, Greece and Ireland), which are now subject to an external financing constraint, while there is no evidence of a similar break for Germany and France. Intuitively, this suggests that while better sentiment continues to translate into higher activity in the core, on the periphery better sentiment may not be able to, because entrepreneurs are unable to raise external financing to put their ideas into practice.
WeconcludethatsomeoftheoptimismonthebasisofrecentmanufacturingPMIs– whichisoneofthefactorsthathasbeendrivingEurozoneinterestrateshigher –maynotsquarewithevidenceof a structuralbreakinthelinkbetweenthe PMIs and growth. While a reading of 50 may in pre-crisis days have indicated positive growth on the periphery, it today may only indicate flat growth, as the external financing constraint prevents better sentiment from translating into activity.
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