Eurozone output increased by 0.4% in the last quarter of the year, with overall growth of 1.7% in 2016. Private sector sentiment has improved significantly since the summer of 2016, and is now close to pre-financial crisis levels.
Eurozone Forecasts Relative to Pre-Trump Election, Q1 2017
Source: Euromonitor International Macro Model
Nevertheless, we have maintained a forecast of 1.3% GDP growth for 2017 (close to the long-term annual growth forecast). The growing strength of populist anti-EU parties, and the threat of weakening EU-US ties under US president Trump raise uncertainty over the outlook in 2017-2018, potentially reversing the current optimism.
While employment has increased faster than expected in 2015-2016, labour productivity growth has disappointed, preventing the Eurozone from breaking out towards a faster recovery from the 2012-2013 recession. As a result, Eurozone output is still almost 11% below its pre financial-crisis trend level.
Despite the recent rebound in Eurozone financial stocks, banks’ balance sheets remain weak (especially in Italy where the government has set aside up to Eur20 billion for bank bail-outs). Greater concerns about populist electoral victories in France and Italy, leading to possible EU and Eurozone exits, also increase the risks of negative shocks to Eurozone financial markets and private sector confidence.
The French presidential election in May is perhaps the main source of uncertainty. The most likely outcome is a victory by 3 rd party centrist candidate Emanuel Macron. However, we now estimate a 30-40% probability of the populist Front National leader Marine Le Pen winning the presidency. If Le Pen is elected, she would seek a comprehensive revision of France’s EU membership conditions, replacing the Euro with new French Francs, and reinstalling border and immigration controls. If the EU leadership refuses Le Pen’s demands (the most likely case), her electoral platform calls for a referendum to leave the EU.
Even if Le Pen becomes president, there are many hurdles to an actual French exit from the EU and the Eurozone. The Front National is unlikely to win a majority in the June parliamentary elections, and without such a majority the EU exit referendum is unlikely to happen. Furthermore, most polls suggest that the French would vote to stay in the EU in any referendum. However, a Le Pen victory would still cause a major shock to financial markets, due mainly to rising default probabilities on French government debt and French Franc devaluation risks.
An Italian parliamentary election in 2017 is another political risk to the Eurozone outlook. Prime Minister Matteo Renzi resigned in December 2016, following the strong rejection of his constitutional reforms in a referendum. While a caretaker government was appointed, there have been calls for an early election. The ruling PD party is scheduled to hold a leadership vote on April 30 th . This makes an election unlikely before September 2017.
Current polls give the anti-Euro 5-Star Movement (M5S) movement and the PD almost equal support, with a slight edge to the M5S. No party is likely to gain the 40% of votes required for an automatic parliamentary majority, and M5S refuses to participate in any coalition. As a result, Italy will probably retain its current pro-Euro coalition government. If M5S wins a parliamentary majority, exiting the Euro in Italy remains unlikely due to constitutional restrictions and strong popular support for the Euro. However, the risks of an M5S victory have already caused a significant increase in Italian government bond yields.
The interaction of political and banking system risks could push the Eurozone into a recession in 2017-2018. A recession starting in the second half of 2017 would cause Eurozone GDP growth to decline to 0.5% in 2017, with a 1.3% contraction in 2018. We assign this scenario an 8-12% probability in 2017, and a 15-23% probability over 2017-2018. On the upside, continuing increases in private sector sentiment backed by pro-EU electoral victories and ongoing progress on structural reforms, could boost growth above expectations. In our growth acceleration scenario, the Eurozone economy expands by 1.7% in 2017 and by 2.8% in 2018. We assign this scenario a 5-10% probability in 2017.
Consumer spending has increased by 1.7% in 2016 (compared to trend growth of 1.5%), and remains the main component in Eurozone economic growth. Consumer confidence has increased substantially in the last quarter of 2016, especially in France. Labour markets have continued to improve. Employment is now 3.1% above its level in mid-2013 (the peak of the Eurozone crisis), and t he unemployment rate declined in December to 9.6% (down from 12.1% in mid-2013). Household real disposable income growth declined in the second half of 2016, but remains slightly above the historical average. Based on these factors, we expect consumption to continue increasing at a 1.2-1.7% annual rate in 2017-2018 (compared to a long-term growth forecast of 1.3%).
Despite the recent growth, the level of consumption is still 10% below the pre-crisis trend level, and this gap is unlikely to close significantly in 2017-2018. The large gap between the Eurozone core and periphery in cumulative spending growth since 2007 is also likely to persist, despite the recent rebound in Spain.
Business conditions and Investment
Investment spending has decelerated in the second half of 2016, though it is still expected to have increased by almost 3% for the whole year. Business profitability and confidence (as measured by the business climate index) have continued improving.
The combination of low financing costs and higher profits should sustain annual investment growth of 2-3% in 2017-2018. However, business investment is quite sensitive to political shocks. The outlook would deteriorate significantly if Marine Le Pen wins the French presidency in May or the 5 Star Movement wins legislative elections in Italy. Even in the baseline forecast the large gap between the current investment and the pre-crisis trend level (currently more than 26%) is likely to remain for many more years.
Financial markets and Monetary Policy
Eurozone stock markets rose at the end of 2016 and in early 2017. Stock prices outside Italy or Spain are mostly above their end of 2015 levels. Eurozone bank stocks in particular have rallied by 45% from their summer lows, and are also close to end of 2015 prices. However, Eurozone banks remain vulnerable to shocks due to low capital buffers. In December 2016, the Italian government put aside up to Eur20 billion for potential bank-bailouts in 2017.
Eurozone long term interest rates have increased by 0.2-0.7 percentage points since October 2016, in line with the rise in US long-term interest rates and a small increase in inflation expectations. However, with the exception of Italy, interest rates are still lower than at the end of 2015. Greater concerns about the risks of the anti-Euro 5-Star Movement winning power in 2017-2018 in Italy and the anti-EU Marine Le Pen winning the French presidency led to a rise in the spread between German and French or Italian government bonds by 0.3-0.5 percentage points.
The ECB has extended its credit and quantitative easing programmes until December 2017 with a moderate reduction in monthly purchases. The recent increases in long-term interest rates and expected inflation suggest the ECB is likely to start tightening monetary policy earlier than previously anticipated, at the beginning of 2019. However, short-term interest rates should remain below 1% until 2022.
Euromonitor International strategy briefing Global Economic Forecasts: Q1 2017 offers further insights on the global economy and provides the latest global macroeconomic projections.