Source: Euromonitor International Macro-Model
General Outlook: growth accelerates despite some political uncertainty
The Eurozone’s economic expansion has strengthened, with growth continuing to exceed expectations. Private sector confidence is close to levels from the early 2000’s, while the unemployment rate has declined to the lowest level since early 2009. Financing costs continue to remain extremely low, despite the prospects for a gradual tapering of the ECB’s financial asset purchases. As a result, we have raised the GDP growth forecast for 2017 to 2.2%, followed by 1.9% in 2018 (compared to a long-term annual trend growth of 1.3%).
The rise in private sector activity and sentiment has occurred despite higher political uncertainty since August. In September, Angela Merkel won a fourth term as Chancellor in the German elections, but the mainstream Christian Democrat (CDU) and Social Democrat (SPD) parties suffered significant losses, barely gaining above 50% of the votes. The populist right-wing party AFD was the big winner, getting 13% of votes. The rise of the AFD to third-party status reflects significant discontent with the political status quo and Germany’s immigration policies, especially in eastern Germany.
In late November, talks for forming a new governing coalition collapsed. Merkel now has to choose between trying to continue with a minority CDU/CSU government, asking the SPD again to form a coalition, or calling a new election. The SPD has previously announced it will go into opposition, but is now open to talks about supporting a minority Merkel government. It may even reconsider its earlier decision to stay out of a coalition. An election would likely occur in the spring of 2018, if no other solution is found. In the meantime Germany would have a weakened caretaker government, likely delaying any major EU decisions on issues such as greater European fiscal and economic integration or on Brexit trade arrangements.
In Spain, Catalonia’s government declared independence, following the October 1st referendum, which was considered illegal by the Spanish government. The central government reacted by suspending Catalonia’s autonomy, disbanding the regional government and declaring new elections for December 21st. For now, these moves have ended the risks of Catalan secession. However, without eventual negotiations addressing Catalonia’s demands for greater autonomy, tensions may rise again in 2018, potentially hurting the recovery in the Eurozone’s fourth-largest economy.
Low long-term growth prospects suggest that the current high private sector confidence levels could be excessive. In our most likely downside scenario, a decline in confidence and falling stock market prices reduce investment and consumer spending. Greater pressure on Eurozone banks’ balance sheets also leads to tighter credit conditions, worsening the decline in spending. Eurozone annual GDP growth is reduced to 1.3% in 2018-2019. We assign this scenario a 15-25% probability.
On the upside, faster than expected productivity and wage growth could accelerate investment and consumer spending and reinforce private sector optimism. GDP growth in this scenario would rise to 2.4% in 2018 and 2.1% in 2019. We also assign this scenario a 15-25% probability over a 1-year horizon.
Private Sector Sentiment and Labour Markets: private sector confidence has increased, and unemployment is falling.
Eurozone economic sentiment continued to rise in October, reaching the highest level since early 2001 (based on the European commission’s index). It is now 14% above its long-term average. Sentiment increased in Spain despite the Catalan constitutional crisis, suggesting a small impact of the extra political uncertainty on private sector confidence.
The strong Eurozone private sector confidence is also reflected in a significantly above average business climate index, ongoing stock market rallies, and highly optimistic profit expectations. Earnings per share for Eurozone corporations are expected to grow by 8.5% in 2018, the highest growth since 2011 (as measured by the EURO STOXX index).
Eurozone labour markets also continue to improve. The unemployment rate has declined to 8.9% in September, down from 9.9% a year earlier and 12.1% at the peak of the Eurozone crisis. Strong employment growth has sustained real disposable income growth close to 2%, despite weak wage growth. Real compensation per worker growth is expected to be close to zero in 2017. Wage increases continue to be constrained by low productivity growth, ongoing slack in some parts of the labour market, and changes in the labour market that have reduced workers’ bargaining power. These include structural reforms that have reduced the bargaining powers of unions and the growing importance of part-time and temporary contract jobs. More capital-intensive production processes and increasing globalisation of labour markets are also contributing to lower wage growth over the long-term. Real disposable income annual growth of 1.5-2% is likely to continue in 2018-2019, with lower employment growth compensated by higher annual real wage growth of around 0.8%.
Aggregate Demand: Investment and consumption lead the recovery.
Eurozone GDP growth increased by 2.4% year- on- year in the last two quarters. Domestic demand is still at the core of the recovery, with net exports making a small positive contribution. Exports accelerated despite the euro’s appreciation, due to stronger global demand from China, the rest of Asia and non-euro EU members. However, the appreciation of the euro since April should dampen net exports going forward.
Investment growth estimates for recent quarters have been revised downwards, though they remain above 3%. High business confidence, low financing costs and rising profits are expected to sustain investment growth at 3.2% annually in 2017-2018. However, lower long-term potential output and productivity growth, together with the slow pace of product and labour market reforms in some Eurozone countries are likely to lower investment growth after 2018.
Eurozone consumption is also expanding faster than its long-term trend, though at a slower pace than overall output growth. Consumption growth is especially strong in Germany and Spain, while it has declined in France. Consumption is expected to grow more slowly than GDP, despite high consumer confidence, low borrowing costs and declining unemployment, due in part to slow real wage growth. Growth for the whole of 2017 is expected to reach 1.7%, followed by 1.6% growth in 2018.
Inflation and Interest Rates: despite low inflation, the ECB will start tapering QE
Inflation remains significantly below the ECB’s 2% target, despite a booming economy and an increase in oil prices. Inflation excluding energy and food prices is barely above 1%. While energy prices have increased, the euro’s appreciation has countered that effect by making imports cheaper. Low wage growth is also contributing to below target inflation. Financial market inflation expectations are significantly below the 2% target, only reaching 1.6% annual average for 2022-2026. Our current forecasts are for Eurozone inflation of 1.4-1.5% annually in 2017-2019, rising towards 1.8% in 2020-2024.
The ECB maintained its policy rates unchanged at its October meeting, while announcing it will taper the pace of its QE programme. From January 2018, financial asset purchases will be reduced from EUR60 billion per month to EUR30 billion per month. This pace will continue until September 2018 or beyond if necessary. The reduction of QE purchases highlights the confidence of the ECB in the strength of the Eurozone recovery. However, the ECB’s policy announcement leaves the length of the QE programme open-ended, with flexibility to continue it indefinitely if the Eurozone recovery stumbles. Eurozone short-term interest rates are still likely to stay close to zero until mid-2019.
Private sector interest rates continue to be at record lows, and bank lending terms have eased a little in recent quarters. Credit markets have continued to recover, with private non-financial sector loans growth at 2.6% year- on- year in September. Demand for business loans in particular keeps rising. However, loans growth is still below long-term averages and the credit to GDP ratio is still falling. Despite recent improvements, Eurozone banks are still suffering from low profitability and low capital cushions, leaving them vulnerable to economic downturns.
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