Source: Euromonitor International Macro Model
We have upgraded our outlook for the Eurozone since February, with GDP growth forecast at 1.5% in 2017 and 1.6% in 2018. The economy has expanded faster than the long-term trend in the first half of 2017, despite high political uncertainty. Private sector confidence is significantly above the long-term average, interest rates remain very low, and labour markets have improved with a 9.5% unemployment rate in March (the lowest since April 2009). The global trade outlook has also improved in recent months, supporting higher Eurozone exports growth. Despite these positive factors, the weak balance sheets of Eurozone banks, low productivity growth and continuing uncertainty about the future of the EU are still constraining the outlook, preventing even faster growth.
On May 7th 2017, Emmanuel Macron won the French presidency, beating Front National candidate Marine Le Pen 66% to 34% in the second round, and putting Frexit risks off the table in the medium-term. While this was already part of our baseline outlook, the outcome of the French presidential elections significantly reduces downside risks to the Eurozone. The large margin of victory for Macron suggests that the recent surge in strength of populist politicians in advanced economies may have been stopped.
Nevertheless, the French presidential elections have still delivered an important warning about the fragility of the current EU status-quo. In the first round, almost 50% of French voters chose candidates from anti-EU or anti-Euro parties. The 34% of votes for the populist Front National candidate is also unprecedented.
Macron now faces a tough job delivering on promises to reduce the chronically high unemployment rate and increase the efficiency of France’s economy. To govern effectively, he will need his En Marche movement to win a majority in the June legislative elections, or a supporting coalition in parliament. Otherwise, he will not be able to reliably implement his pro-business economic agenda.
The Eurozone remains subject to significant recession risks. An increase in uncertainty about the survival of the EU (e.g. due to concerns about an Italian exit), a decline in private sector confidence and a deterioration in bank balance sheets could cause GDP growth to decline to 0.7% in 2017 and -1.2% in 2018. We assign this scenario a 7-11% probability over a one-year horizon. On the upside, greater confidence in the future of the EU and the Euro following Macron’s victory in the French presidential elections, and faster than expected progress on banking and structural reforms could raise GDP growth to 1.9% in 2017 and 2.9% in 2018. We assign this scenario a 6-11% probability over a one-year horizon.
Private Sector Sentiment and Financial Markets
Eurozone private sector confidence has improved substantially over the last year. According to the European Commission’s index, economic sentiment in April reached the highest level since the summer of 2007. Both business and consumer confidence increased, with consumers upgrading their expectations on overall economic conditions and future household finances, while lowering their expected unemployment risk. Firms improved their assessment of current demand conditions and export prospects. As a result they significantly raised their hiring and investment expectations. The strong victory of the pro-business Emmanuel Macron in the French presidential elections should significantly boost business confidence in France, with modest spill-overs to the other main Eurozone economies.
The recent rebound in Eurozone stock market prices has continued at a more moderate pace in recent months, reaching the highest level since the summer of 2015(based on the Euro Stoxx index). Bank stocks in particular have continued to do well, reducing financial system stress. However, Eurozone banks continue to suffer from low profitability, a high proportion of non-performing loans, and excessive leverage levels. This limits their ability to expand credit and support business investment.
Consumption and Investment
Eurozone consumer spending increased by 1.9% in real terms during 2016, compared to overall output growth of 1.7%. While consumption growth slowed down in Germany, it was still growing quite fast in Spain at the end of 2016. Italy remains a weak point of the Eurozone recovery, with consumption growth slowing down to less than 1% at the end of 2016. In addition to rising consumer confidence, strong real disposable income growth above 2% has sustained spending. Income has increased mainly due to rising employment. Real wage growth remained disappointing at 0.7% year-on-year at the end of 2016, mainly due to continuing low labour productivity growth and some remaining labour market slack. Wages are unlikely to grow much faster in 2017-2018, constrained by labour productivity growth of 0.5-1% annually.
Eurozone consumption is expected to grow by 1.6% annually in 2017-2018. This balances the ongoing improvements in consumer sentiment and expectations, with slower recent retail sales growth and sluggish real wage increases.
Eurozone investment reached 5% year-on-year growth at the end of 2016. As a result, investment expanded by 3.5% in 2016, up from an already strong 3% in 2015. Borrowing costs continue to be historically low, and business confidence has improved. However, much of the burst in spending during 2015-2016 represented a rebound after the decline in capital stocks during the 2011-2014 Eurozone crisis. Looking forward, there is less scope for growth from rebuilding capital back to normal levels. Furthermore, non-interest rate bank lending terms (for example collateral requirements or other maximum borrowing restrictions) are still significantly tighter than before the Eurozone crisis. According to the ECB banks survey, while lending terms eased in the first quarter of 2017, banks expect a slight tightening of borrowing conditions for business in the second quarter. Therefore, investment in the Eurozone is likely to decelerate to around 2.5% annual growth in 2017-2018 (compared to long-term trend growth of around 2%).
Interest Rates and Inflation
Eurozone inflation in the first quarter of 2017 increased to 1.8% year-on-year. However, core inflation excluding fuel and food costs is still stuck close to 1%. The rise in inflation towards the ECB’s 2% target seems to be mainly due to the temporary boost from higher recent oil prices, with continuing low inflation in many sectors. Based on financial market measures and the continuing low core inflation, we expect Eurozone annual inflation of 1.6% in 2017-2019, staying moderately below 2% until the middle of the next decade.
The increase in global interest rates since November 2016, and the higher risk premium on French and Italian sovereign bonds have had only a small impact on private sector financing costs. Mortgage and business loan rates have barely moved since the middle of 2016. In real terms, these private sector rates are close to zero, with expected inflation now solidly anchored at 1.5-2% over the next five years.
The ECB has not changed monetary policy in recent meetings, despite improving economic conditions. It appears to have adopted a “wait and see” attitude, delaying any significant moves until the French presidential election results are known. With Emmanuel Macron becoming the new French president and the end of Frexit risks, the ECB is expected to unwind its current quantitative and credit easing programmes more quickly during 2018-2019. However, it is unlikely to start raising short-term interest rates before the first quarter of 2019.
Euromonitor International strategy briefing Global Economic Forecasts: Q2 2017 offers further insights on the global economy and provides the latest global macroeconomic projections.