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eurozone graph

Source: Euromonitor International

Baseline outlook: Expansion slowing down, but still some momentum left.

Eurozone growth has slowed down since the end of 2017 to a still solid 2.5% year-on-year growth in the first quarter of 2018 (compared to a long-term annual growth rate of 0.8-1.8%). Private sector sentiment has declined slightly, though it remains high. External financing costs have also started to rise, but they are likely to remain low over a 5-year horizon. Eurozone stock markets have declined from their peak in late January, but they are still fairly valued or even undervalued. Labour markets have continued to improve, with the unemployment rate declining to 8.5%, though accompanied by low real labour compensation growth of 0-0.5% annually.

Eurozone GDP is forecast to increase by 2-2.6% in 2018 and by 1.5-2.3% in 2019, down from 2.5% growth in 2017. Investment and net exports are responsible for most of the outperformance relative to the long-term trend. Fixed investment is expected to grow by 2.9-4.7% in 2018 and by 2.1-4.3% in 2019, while consumption growth is expected to continue at a slower pace of 1.4-2% in 2018 and 1.4-2.2% in 2019. The economy is likely to continue expanding faster than average in 2020-2021, but subsequently, employment growth is likely to slow down, while annual labour productivity growth is unlikely to rise above 1%. As a result, the Eurozone is likely to converge to a long-term potential annual growth rate of 0.8-1.8%.

In early March, Germany’s SPD party members agreed to form a coalition government with the CDU/CSU, and Angela Merkel started her fourth term as German Chancellor. The coalition agreement resolved several months of political uncertainty and set the groundwork for strong German-French collaboration on solidifying the Eurozone’s fiscal and monetary institutions.

EU and UK negotiators announced reaching a deal on the Brexit transition period in mid-March, allowing negotiations to continue to the discussion of a final trade agreement. The transition period should last for 21 months until December 2020.

Estimated baseline forecast probability: 20-30% over a 1-year horizon.

Forecast Risks

Most likely pessimistic scenario: significant declines in private sector confidence due to fears of a trade war and the growing influence of populist parties, falling stock market prices and rising corporate bond yields lead to higher costs of financing. Falling Eurozone bank stock prices and higher bank borrowing costs cause a significant tightening in credit standards. GDP growth declines to 1.7-2.3% in 2018 and 0.4-1.2% in 2019.

eurozone graph

Source: Euromonitor International 

Estimated scenario probability: 15-25% over a 1-year horizon.

Most likely optimistic scenario: the 2017 growth momentum turns out to be more persistent, with businesses more aggressive in investing to replace ageing capital. Eurozone stock markets fully recover from the declines in the first half of 2018 and finish the year up by 5-15% relative to the end of 2017. In combination with stronger progress on Eurozone structural reforms and more moderate than expected policies from the new populist government in Italy, this causes a further increase in private sector confidence.  GDP growth reaches 2.2-2.8% in 2018, followed by 2.2-3% growth in 2019.

eurozone graph

Source: Euromonitor International 

Estimated scenario probability: 15-25% over a 1-year horizon.

eurozone graph

In the Italian elections on March 4th, the populist M5S and the (ex-Northern) League parties got the majority of the votes, with the more mainstream left-of-centre PD and right-of-centre Forza Italia (Silvio Berlusconi’s party) relegated to third and fourth place. On May 18th, M5S and the League agreed to form a coalition after lengthy negotiations.

Both M5S and the League have already abandoned earlier promises to hold a referendum on leaving the Eurozone. Italian Eurozone exit probabilities are still estimated to be quite low at 0-5% at a 1-year horizon. However, their programme will likely imply a significant rise in government spending without higher taxes, leading to much higher government deficits. Ultimately, this could revive fears of a sovereign debt crisis in Italy. Relations between the new populist Italian government and its key Eurozone partners could also raise political uncertainty.

Meanwhile, concerns are rising that US President Trump will go ahead with imposing tariffs on EU steel and aluminium imports in June. The EU is likely to retaliate with some tariff increases on a restricted set of US imports such as motorcycles and bourbon. The impact on Eurozone GDP of these tariffs is likely to be modest at 0-0.2% over 2018-2019. A more full-blown trade war between the US and the EU, for example with an average bilateral tariff increase of 10 percentage points, would do more damage. But the impact would still be moderate, with the Eurozone GDP level declining by 0.2-0.7% relative to the baseline forecast over 2018-2019.

Private sector sentiment: Still optimistic, but no longer rising

Economic sentiment indices are still significantly above long-term averages but have declined slightly since the end of 2017. Consumer confidence has barely changed since the end of 2017, though it remains significantly above average.  At the country level, Italian consumer confidence has increased significantly since mid-2017, while French consumer confidence has declined. Other surveys such as the Sentix investor sentiment index also show a decline in confidence in recent months. Meanwhile, purchasing managers’ indices have declined in early 2018, though they remain consistent with an annual GDP growth rate of 2-2.5%. All these indicators point to a modest slowdown in growth in 2018, relative to the fast pace of 2017.

eurozone graph

eurozone graph

Monetary policy and credit conditions: Credit conditions remain loose, though interest rates will rise very gradually

Credit conditions have remained loose overall, despite modest increases in certain interest rates. The ECB has maintained monetary policy unchanged in recent meetings. However, in March it removed from its policy statement the possibility of expanding quantitative easing (QE) if necessary. This suggests a slight tightening of the monetary policy stance and a reduced perception of the risk of negative shocks. QE asset purchases are expected to end in September 2018.

We continue to expect a slow increase in interest rates, with monetary policy rates only reaching their long-term value by 2025-2026. Even then, Eurozone interest rates will likely remain far below their pre-Global Financial Crisis (GFC) level, close to zero in real terms.

eurozone graph

Longer-term Eurozone interest rates have increased slightly since the end of 2017, though they remain quite low by historical standards. The spread between Italian and Spanish versus German bond yields has declined significantly since mid-2017. Italian government bond yields increased by around 0.3 percentage points in May, as it became clear that the populist M5S and League parties have succeeded in forming a coalition. Nevertheless, financial markets still seem to be pricing in a mild outlook on the risks of Catalan secession from Spain and low risks of an Italian Eurozone Exit.

Eurozone stock markets have mostly recovered, after declining by almost 10% in January-March, and are now down 2.5% from the beginning of the year (based on the Euro Stoxx index in mid-May). Continuing low-interest rates and the strong improvement in corporate earnings imply that Eurozone stocks may be moderately undervalued. Without negative global shocks, the recent rebound in stock prices should continue for the rest of 2018.

eurozone graph

eurozone graph

Eurozone bank lending standards have loosened in Q1, especially for business loans. They are likely to continue easing in the rest of 2018. Loan demand has also continued rising. Private sector loan growth is now above 3% year-on-year, representing a significant improvement since the negative growth in 2014, but still below nominal GDP growth.

Aggregate demand: Investment boom likely to continue.

The contribution of consumption to the recent Eurozone expansion has been more modest than in past recoveries, with consumption growth of 1.7% in 2017 (compared to 2.5% GDP growth). While consumer confidence is high and the unemployment rate has declined to 8.5% (compared to a Eurozone crisis peak of 12.1%), real wage growth has been close to zero and is expected to remain below 1% annually over 2018-2022.

Real disposable Income growth of 1.4-1.5% year-on-year has come almost exclusively from employment growth at the end of 2017-early 2018. In 2018-2019, a slowdown in employment growth is expected to be offset by faster wage growth. As a result annual real disposable income growth is likely to increase to 1.5-2%. Beyond that annual real disposable income growth is likely to decline to 0.8-1.8%. Household borrowing costs should remain low, despite gradually rising interest rates. Based on these factors, consumption growth is forecast at 1.4-2% in 2018 and 1.4-2.2% in 2019, declining to a long-term growth rate of 0.8-1.8% after 2020.

eurozone graph

Investment has been one of the main components of the recent Eurozone boom. Businesses are catching up with the large backlog in investment since the 2008 GFC, which has led to an ageing capital stock. In combination with low financing costs and strong profit expectations, this has supported fixed investment growth of 3.3% in 2017. Investment growth is likely to accelerate to 2.9-4.7% in 2018, declining to 2.1-4.3% in 2019. Upside risks such as faster implementation of structural reforms in countries like France and Spain, a stronger rebound in stock markets or stronger momentum from 2017 growth could propel investment growth towards the upper range of these intervals. Downside risks to investment include heightened uncertainty related to trade wars, more populist policies in countries such as Italy, and negative financial shocks to stock markets and credit markets.

eurozone graph

To learn more, download the strategy briefing Global Economic Forecasts: Q2 2018, offering further insights on the global economy and the latest global macroeconomic projections.

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