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Eurozone Economic Sentiment Improves, But Analysts Not Hopeful

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Eurozone manufacturing and sentiment showed marginal improvements in January, but analysts were cautious about calling a turnaround
Eurozone manufacturing and sentiment showed marginal improvements in January, but analysts were cautious about calling a turnaround

European leaders were given a glimmer of hope ahead of Monday's summit, as sentiment and demand in the eurozone defied expectations to rise. The flash purchasing managers' index (PMI), an indicator of demand, rose above 50 points in January - the level that typically indicates an expansion.

Consumer and business confidence figures also rose in January, after the previous 10 months had seen the number fall, hitting a two-year low in December 2011.

Exports - largely due to the robust performance of the German manufacturing sector - drove the improvement in sentiment, while services also showed some improvement. Retail sentiment, however, fell to a 31-month low.

Markets have been cautious about interpreting these figures as signs of a real turnaround, but any indication that the economy in the eurozone is beginning to stabilise would be welcome as the unresolved sovereign debt crisis in Greece continues to cast a shadow over the single currency zone.

"While this is a boost for hopes that Eurozone economic activity may be stabilizing, the fact remains that sentiment is still at a low level and the Eurozone is far from out of the economic woods," Howard Archer, chief European economist at IHS Global Insight, said in an email.

Some of the boost may, analysts said, be a function of an improvement of the credit environment. Banks in the eurozone have been taking advantage of a programme of cheap loans from the European Central Bank (ECB) - the Long-Term Refinancing Operation (LTRO), which offered three-year finance at a concessionary rate of 1%.

When it was announced in December, the LTRO, seen by some as a form of back-door quantitative easing, prompted a rally in eurozone stock markets and may also have driven positive sentiment in companies elsewhere in the real economy by showing that the ECB was capable of taking decisive action.

However, analysts note that the liquidity-driven improvement may not last, as banks still need to build up capital buffers to protect themselves in the event of future shocks. This means that many are still likely to reduce their overall lending, or "de-lever."

"We have been surprised by the strength of the PMIs, but we continue to expect further weakness," Deutsche Bank strategists Michael Biggs and Gareth Evans wrote on Monday.

"The LTRO might have solved the funding problem for banks, but the need to de-lever is still likely to weigh on credit growth. The fall in credit growth at a time of fiscal austerity should prove a significant drag on domestic demand, and we expect further weakness in the coming months. In our view domestic demand growth in the euro area is contracting sharply, and the relative strength of the PMIs is due to robust net exports. The contribution from net export to GDP growth can be volatile, and we expect further weakness in the region in the coming months."

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