‘A tale of two Europes’ seems to be the best way to describe the slew of Q2 GDP releases that came out in the second week of August. On the upside, Germany and France, the two largest eurozone economies, surprised most analysts by surging out of recession and posting 0.3% q-o-q growth. This helped to lift aggregate eurozone Q2 GDP to -0.1% q-o-q, up significantly from the -2.5% recorded in the previous quarter. At the same time though, long weak economies including Spain (-1.0% q-o-q), Italy (-0.5%) and Austria (-0.4%), remained mired in recession. So, what to make of this dichotomy?

Europe - Selected Countries, Real GDP, % q-o-q

Well, two things spring to mind. First, the strong improvement in Germany is likely reflective of the boost to external demand provided by macroeconomic stabilisation in Asia, namely China. Contrary to some crisis risk scenarios, the bottom has not fallen out of the Chinese demand dragon, especially with Beijing pouring in stimulus spending and specifically targeting infrastructure investments. While the most notable effect of PRC spending has been indicated in the commodities markets, the demand for capital goods has also likely been driven higher by government-driven spending. Second, it is evident that the countries which are performing better in Western Europe are those which entered into the crisis with healthier banking systems and lower levels of leverage.

To be sure, the dichotomy in Western Europe is also playing out in the East. Thus far, eight emerging European countries (Czech Republic, Slovakia, Russia, Romania, Estonia, Latvia, Lithuania, Hungary) have released Q2 GDP data with similar factors underpinning divergent dynamics. Of the eight, seven countries showed a marked deterioration in real GDP growth (in y-o-y terms), with only Slovakia improving to -5.3% y-o-y (from -5.6% in Q109). That said, it is crucial to note that despite the fact that the Czech Republic’s rate of contraction in y-o-y terms accelerated, in q-o-q terms the country actually pushed out of recession. It is not surprise that both the Czech Republic and Slovakia, two of the most trade integrated economies with Germany, were among the best performing in CEE. The banking sector factor also helped to bolster these two economies, with both maintaining some of the lowest leverage and external debt ratios in the entire emerging Europe region.

In CEE though, it is not just the trade and leverage factors which are worth following to understand the relative outlook. As an emerging market, the role of currencies and specifically, the flexibility of the FX regime will be an essential component to understand the shape of the recovery process. Surely it is not a coincidence that five of the six countries where the recession deepened further in Q2 either maintain strict fixed exchange rate regimes or manage their currencies in some form. By holding to artificially inflated exchange rates, especially in the Baltics, the necessary adjustment to the external asymmetries built into these economies will have to play out in the form of sharper and more protracted periods of output reduction, ergo: deeper headline recessions.

Europe - Selected Countries Real GDP, % y-o-y

Ok, so relative value is on, but can we take any thing else from the GDP releases? In short, the trough is nigh! The Q2 data, especially from the core eurozone states of France and Germany, confirms leading indicator data that was increasingly showing signs that the recession troughed in H109. When combined with the stabilisation in capital market conditions beginning in March, this clearly implies that we are entering into the recovery phase of the current economic cycle. While some countries, especially in CEE, will be later to the recovery than others, I think its safe to say now that the worst of the macroeconomic crisis risks have been mitigated.

While I will breath a sigh of relief on that note, I’m not about to jump for joy either. This recovery process will be weak and fragile, driven mainly by base effects, a necessary reduction in the output gap and re-stocking, as opposed to any fundamental recovery in aggregate demand conditions (China alone is insufficient to drive global demand). In other words, we’ll have to wait until 2010 before we can truly look at this recession in hindsight.