Euroland: Ifo Signals Further Weakness Ahead

Overview: The main Ifo index dropped in August from 97.5 to 94.8; thus, the index has fallen steeply over the past three months. The decline today was not totally unexpected by the market following the fall in the PMI last week.

Today's drop was driven by both lower expectations, from 89.9 (revised from 90.0) to 87.0, and a more pessimistic assessment of current conditions, declining from 105.2 (revised from 105.7) to 103.6. The fall in expectations is most significant as it is the best leading indicator within the Ifo index. Also expectations had a lower starting point.

The deteriorating business climate is broadly based across sectors, with wholesale being the notable exception. Importantly, the manufacturing sector went from 95.8 to 91.6 as expectations slid from 87.1 to 82.6. According to the Ifo, companies expect weaker exports, in particular.

Outlook and assessment: The dramatic drop in the Ifo in recent months clearly indicates that the German economy is increasingly affected by the slowdown in export markets. We have already seen a clear slowdown in consumption (which contracted for the third consecutive quarter in Q2) and slower export growth. As confirmed by today's detailed national account for the German economy, this is impacting investments. Going forward, we think activity in this area will remain weak. This is bad news for the German economy, and therefore also Euroland as a whole as Germany was more or less the "last man to fall". In the second half of 2008, the German economy is likely to stagnate, and a technical recession is not an unlikely scenario.

The drop in expectations indicates that the lower oil price and weaker euro have so far been unable to overcome weaker demand. In particular, we think the deteriorating outlook for the central and eastern European economies is increasingly weighing on German exporters.

We continue to expect the ECB to be sidelined for now, as the current environment does not give room for the ECB to either hike or cut rates. Furthermore, the weakening of the German economy does not come as a surprise. We expect a continuation of this development in the quarters ahead, which should intensify pressure on the ECB for a rate cut.

Danske Bank

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