Eurozone’s Cyclical Rebound Continues, but Risks Rise
The eurozone cyclical recovery is set to continue at a moderate pace, but downside risks have further increased, with what were once likely tailwinds for growth now either ineffective or becoming headwinds, and a slowdown (or even recession) cannot be ruled out.
At the aggregate level, the eurozone grew by 1.5% in 2015, and we expect growth of 1.5% and 1.6% in 2016 and 2017, respectively. Consumption remains the key driver as real disposable income improves, but investment is not picking up, despite significant monetary easing and better lending conditions. Also, the euro has not depreciated enough to support exports. Sentiment indicators remain, on average, positive, but in some cases are deteriorating. Yet, the eurozone’s composite purchasing managers’ index (PMI) was 53.6 in January, consistent with a continuation of the Q4 expansion.
Germany, the key for eurozone growth and confidence, is under increasing economic and political pressure. Momentum was sustained in Q4, with full-year growth at 1.4%, supported by private consumption and fiscal spending on refugees. However, the sluggish external demand is keeping the German growth model under stress, with industrial production contracting in the past few months.
The migrant crisis is leading to increasing fiscal spending, but risks undermining political stability and Angela Merkel’s leadership position in Germany and the EU. Moreover, the difficulties facing Deutsche Bank and Volkswagen could prove systemic, and may require a government bailout to prevent contagion.
The political limbo continues, with implications for confidence indicators and investment. The economy grew by 3.2% in 2015 with consumption supported by rising employment and employment prospects, but we expect a deceleration in 2016 to around 2.6% as base effects wane and the lack of government leads to delays to investment, with potential repercussions for growth and spread-widening vis-á-vis other periphery countries.
Moreover, Spain’s compliance with the EU’s fiscal rules and the continued implementation of structural reforms also seem in doubt. Reflecting on this, Moody’s recently changed the outlook on the sovereign rating to stable from positive. On the political front, we believe a “grand coalition” remains the most likely scenario after the Socialist Party’s Pedro Sanchez fails to form a left-wing government, but the probability of a new election has risen from a month ago.
France remains behind Spain and Germany in the recovery cycle, with soft domestic demand and decelerating growth in Q4, partly as a result of the temporary shock to sentiment after the Paris terrorist attack.
Overall, growth accelerated in 2015 from 2014, but PMI remains at 50.2 and confidence indicators are only timidly positive. Moreover, the reform-minded prime minister is at risk of being ousted or undermined, which we believe could be detrimental for France’s growth prospects. His pro-austerity policies seem likely to undermine President Francois Hollande, who has vowed to lower unemployment, ahead of the 2017 election.
Italy’s economy moderated toward year-end 2015, with 0.1% q/q growth in Q4 disappointing expectations, but it was still able to grow at 0.6% over the full year. As in other countries, the sluggish external demand has weighed on growth, and high-frequency indicators are mixed on the economy’s prospects in 2016: Consumer confidence remains high, but business confidence has declined.
Composite PMI of 53.9 continues to indicate expansion, but retail PMIs on sales and margins remain below the 50 mark. The country was able to negotiate some extra fiscal flexibility from the EU, but it has not been given enough leeway to be able to cope with the economic burden of the migrant crisis. Although the “Catholic Jubilee” will have a positive one-off effect on 2016 GDP, huge structural challenges remain.
Downside Risks Abound: An Accident Waiting to Happen
Although the eurozone economy still has some momentum, at least in the short term, the region is facing a number of simultaneous crises and has very limited policy options with which to respond to any shocks.
The potential for a new crisis in the region cannot be ruled out. The factors that initially provided a tailwind to the recovery are no longer working or have even become headwinds as risk aversion increases, hitting confidence indicators and reinforcing the market sell-off.
Moreover, the rise of populism and geopolitical risks are leading to concern about the region’s ability to cope with so many possible “triggers” for a crisis and their potential economic repercussions. In response, we expect the European Central Bank to ease monetary policy further but, with risks continuing to rise (not least in the context of the attacks in Brussels), that might be insufficient to bolster the recovery.