Source: Euromonitor International Macro Model
General Outlook: Greater Optimism and Lower Political Risks Sustain Faster Growth
After many years of disappointing growth, the Eurozone economy is booming. Eurozone GDP is estimated to have increased by 2% year-on-year in the first half of 2017. This is similar to growth in the US economy, however it is significantly above the Eurozone’s long-term trend growth rate of 1.2% (while US growth is barely above trend). In line with the strong first half performance, we have upgraded our Eurozone GDP growth forecasts to 1.8% in 2017 and 1.7% in 2018. As in previous quarters, the aggregate Eurozone numbers mask significant divergence inside the bloc. GDP growth in 2017 is expected to range from 2.9% in Spain and 1.7% in Germany, to 1.5% in France and just 1.1% in Italy. Nevertheless the outlook in all countries has improved significantly since the beginning of 2017.
Labour markets have improved, interest rates remain very low and bank lending terms have loosened. Private sector sentiment has continued to increase, and is now 11% above its long-term average. Consumer confidence is also significantly above the long-term average, especially in France. In contrast, Italian consumer confidence is below average, in line with a more generally weak economic outlook in Italy.
Political risks have receded after the election of the pro-EU Emmanuel Macron as the French president in May, and the majority won by his La Republique en Marche (LREM) party in the June legislative elections. The big populist upsurge that was considered a major risk for 2017 has not materialised. Populist parties have systematically underperformed in Eurozone elections relative to the polls, and the rise of populism in the Eurozone may have peaked.
Downside risks to the Eurozone outlook have declined since May 2017. We have reduced the probability of a Eurozone recession to 5-10% over a 1-year horizon. In our most likely pessimistic scenario, low wage and productivity growth lead to a decline in private sector confidence and a 10-20% stock market correction. GDP growth would decline to 1% in 2018. We assign this scenario a 15-25% probability over a 1-year horizon. In our most likely optimistic scenario, labour productivity and wages rise faster than expected, private sector confidence continues to increase and GDP growth increases to 2.4% in 2018. We assign this scenario a 15-25% probability over a 1-year horizon.
EU and UK Brexit negotiations have started during the summer, after British PM’s Theresa May failure to secure a strong parliamentary majority in the June elections. For now there is significant disagreement between the EU and the UK (and inside the UK government) on key issues, such as the amount the UK should pay as compensation for leaving the EU, the rights of EU citizens in the UK and the nature of the final trade deal.
Our baseline forecast assumes the EU and the UK reach a free trade agreement, with more restrictions on services and more non-tariff barriers than in the current common market, by 2020-2022. In the interim, the UK is likely to continue as a de-facto EU member without any voting rights. However, even in a more adverse scenario in which negotiations break down without any deal, the economic impact on the Eurozone is likely to be modest. In the no-deal Brexit scenario, Eurozone GDP growth in 2019 would decline by less than 0.4 percentage points relative to the baseline forecast.
Consumption and Investment: Consumer Spending is Held Back by Slow Wage Growth, while Investment is Booming
Eurozone consumption growth has slowed down to 1.6% year- on- year in the first half of 2017 (down from 1.9% in Q4 2016), even as GDP growth has increased. As a result, the gap between long-term trend and actual change in consumption since 2012 has remained unchanged. Consumption is expected to continue increasing at a 1.5-1.6% annual rate in 2017-2018, moderately below GDP growth. This highlights a more investment and net exports led recovery, despite high levels of consumer confidence. The main constraint on consumer spending is low disposable income growth. Employment growth has stayed around 1.5% in recent quarters. However, it is expected to slow down towards 1% by 2018. Meanwhile, wage increases have been close to zero after adjusting for inflation.
Eurozone fixed investment has increased in recent quarters by 5-6% over the previous year. Investment is now close to its long-term trend for 2012-2017. However it is still badly lagging in Italy. Low capital stocks, higher business confidence, low financing costs and improving profitability and demand conditions should continue to encourage business investment. We expect Eurozone fixed investment to increase by 4.3% in 2017 and by 2.8% in 2018.
Labour Markets and Productivity: Unemployment Is Falling but Wage Growth Remains Weak
The Eurozone unemployment rate has declined by three percentage points from its early 2013 peak to 9.1% in June, with employment growth of around 1.5% in 2016 and early 2017. The change in prime working age employment rates (a more robust measure of labour market strength that allows for discouraged worker effects) has been smaller, suggesting more moderate labour market improvements. The Eurozone employment rate has increased by two percentage points from its early 2014 low, and there is significant variation in labour market performance. The employment rate in France is still below its level during the 2011-2013 Eurozone crisis, and has barely increased since early 2015. Italy’s employment rate is only slightly above its level in 2013. In contrast, Spain’s strong labour market recovery is reflected in an employment rate increase of 7 percentage points since 2013.
While employment is recovering, wage growth remains weak. Average real wage annual growth in the 2014-2017 economic recovery has been just 1.1%, and it was close to zero in the first quarter of 2017. To a large extent, this can be related to low labour productivity annual growth below 1%. Labour productivity growth is likely to stay below 1% in 2017-2019. However, there are also some signals that lower bargaining power of workers (due to labour market reforms and higher job loss fears after the Eurozone recession) is holding back wage growth.
Financial Markets and Monetary Policy: Inflation Remains Low Despite a Booming Economy
Eurozone inflation has declined to 1.3% year-on-year during the summer, and is again significantly below the ECB’s 2% target. Core inflation excluding food and energy prices was also 1.3% year-on-year in July. The low core inflation measure of close to 1% throughout 2017 is hard to square with a traditional story of higher demand driving the Eurozone recovery, which would lead to higher inflation. It is also incompatible with the recent moderate oil price fluctuations in a range of 44-56 USD per barrel (for Brent crude oil). Instead, it seems supply side factors, such as labour market reforms moderating wage growth, have played an important role in the recent recovery.
The ECB has kept short-term interest rates unchanged in its latest meetings, balancing concerns over lower inflation with higher economic growth. However, it has eliminated earlier reference in its policy statement to potential further interest rate cuts. This amounts to a slight tightening in the monetary policy stance, reflected in an increase in long-term Eurozone interest rates in July. The ECB is still expected to keep its main policy rate below 1% until 2021. Financial asset purchases under the quantitative easing programme are expected to continue throughout 2017-2019.
Long-term interest rates continue to signal low ECB rates continuing well into the 2020s. The victory of the pro-EU Emmanuel Macron in France’s presidential elections, together with the legislative majority won by his pro-EU party LREM, have contributed to a reduction in the spread between French and German interest rates by almost 0.4 percentage points since April. The spread between Italian and German government bonds has also declined by a similar amount, due to the declining probability of early elections in 2017 (with the risk of the anti-EU M5S party winning).
Eurozone stock markets continued to rise in the first half of 2017, declining slightly since May. Stock markets have returned to same level as in mid-2015. Despite some concerns about potential overvaluation, European stock markets’ price-to-earnings ratios are close to the average for the last 25 years. As a result, we expect stock markets to continue rising moderately in 2017-2018 in our baseline forecast. The main downside risks to Eurozone stock markets are our advanced economies stagnation scenario (assigned a 10-15% probability over a 1-year horizon), or the Eurozone recession scenario (assigned a 5-10% probability over a 1-year horizon). These scenarios could lead to a 20-30% decline in stock prices.
In our latest report extract, we provide you with an update on our latest macroeconomic forecasts for key economies and what these mean for our predictions for the global economy. Download Global Economic Forecasts: Q3 2017 to stay ahead of risks and opportunities as they emerge on a macroeconomic basis.