Brexit shocks Eurozone markets, clouds region's futur

Brexit shocks Eurozone markets, clouds region's futur

June 27, 2016

In a shocking and groundbreaking referendum, the United Kingdom voted to leave the European Union on 23 June, rattling financial markets and throwing the EU into unchartered territory. No country has ever left the EU and the decision has brought with it massive uncertainties in terms of economic ramifications. The immediate economic consequences were felt in financial markets, which had not anticipated the outcome. Global stock markets plummeted the day after the vote and, in the Eurozone, the Italian and Spanish stock markets recorded the largest one-day drops on record, with banks hit particularly hard. In addition, the euro came under pressure, while safe-haven German 10-year bond yields plummeted into negative territory to hit a new record low.      

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Brexit negotiations are set to dominate the political dialogue in the Eurozone in the coming months and even years. According to European Union regulations, once formal notice from a member country has been given, a two-year period is set for negotiating an exit—with a possibility for extension. Given the complexity of negotiations, discussions are likely to drag out and when the United Kingdom will actually give formal notice remains unknown.

Regarding economic implications, in the short term, the Eurozone economy will likely face heightened volatility in financial markets and lower confidence levels. The former could impact monetary policy and investment in the bloc will most likely take a hit as a result of the latter. The impact of financial market vibrations could be particularly pronounced for the periphery nations such as Italy and Spain. However, strong domestic fundamentals, which have supported the Eurozone’s recovery so far—regional GDP expanded by a one-year high of 0.6% quarter-on-quarter in Q1—should buttress growth in the near term as uncertainty over the terms of Brexit lingers.

In the longer term, the impact of a Brexit is less clear and dependent upon how negotiations between the two concerned parties evolve. The UK is the Eurozone’s second-largest trading partner and barriers to trade on top of a projected slowdown in UK growth will likely hurt the region. More ambiguous will be the possible changes to foreign direct investment patterns, migration and fiscal transfers within the bloc. On top of this, there is a risk that Brexit could fuel Euroscepticism and nationalistic sentiment across the region and spark other members to question their membership in the union.

Meanwhile, a repeat election in Spain has failed to provide a clear end to the political impasse that has characterized the country for months. The second general election in six months on 26 June yielded a broadly-unchanged result with no party or potential coalition able to control an absolute majority of seats. The result paves the way for another round of tough coalition negotiations and economic reforms will remain at a standstill. 

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Eurozone’s outlook stable as panelists take the latest developments into account

While the Eurozone economy started the year off on solid footing, downside risks to the growth outlook have risen following the UK’s Brexit vote. Our panel is still factoring the latest developments into their forecasts and are expected to gradually adjust to the new situation in the coming weeks. The current projection is for the Eurozone economy to grow 1.5% this year amid an improving labor market, ultra-loose monetary policy and less-tight fiscal policy. For next year, our panel currently sees growth stable at 1.5%.

Regarding the economies in the Eurozone, analysts left their 2016 GDP projections unchanged for 10 of the 19 countries in the region, including major players Italy and Spain. Meanwhile, analysts’ forecasts were revised down for four countries, including GermanyGreece and Latvia. The panel revised upwards the forecasts for five countries including Finland and France

GERMANY | Growth picks up on robust fixed investment

Germany’s economy started the year on a strong footing in Q1 as the economy unexpectedly tallied the fastest expansion in two years. The pickup in Europe’s largest economy was mainly driven by solid fixed investment, which benefited from surging construction activity during the mild winter, and robust private consumption, which continued to be buttressed by a healthy labor market, loose monetary policy and still-low oil prices. On the downside, the external sector continued to hamper growth. Recent indicators suggest that the economy continued on a resilient, albeit somewhat slower, growth path in Q2. While weakness in exports persisted in April, industrial production performed robustlyThe composite PMI signaled expansionary business conditions from April to June and business confidence hit a seven-month high in June.

Germany’s growth outlook for this year is fairly stable as healthy domestic demand is seen to more than offset a lackluster external sector. Thanks to its solid economic fundamentals, the German economy will likely withstand the immediate financial and economic turmoil brought about by Brexit. Nevertheless, rising anti-EU sentiment and uncertainty regarding EU disintegration pose downside risks in the longer term. The current Consensus Forecast is for GDP to grow at a steady pace of 1.6% this year, which is down 0.1 percentage points from last month’s forecast. For 2017, panelists also forecast a 1.6% expansion.

FRANCE | Government and labor unions remain at impasse

The French economy accelerated to a one-year high in the first quarter on the back of resilient private consumption and fixed investment. High-frequency indicators suggest that the economy has lost some steam in the second quarter due in part to the ongoing strikes over a controversial labor reform bill. In June, the Manufacturing PMI slipped back into contractionary territory and business confidence dropped to a one-year low. In the political arena, the standoff between the government and hardline labor unions continues. The first meeting in months between the government and labor unions did not yield a result and with neither side willing to compromise, there is no end in sight for the standoff.

While the government’s labor reforms promise to liberalize the labor market and rekindle growth in the medium term, the widening protests against the labor bill are likely to put a dent in economic activity in the short term. The outcome of the Brexit referendum in the UK could fuel Euroscepticism and increase political uncertainty ahead of next year’s presidential election. Analysts expect the economy to expand 1.5% in 2016, which is 0.2 percentage points from last month’s forecast. Panelists expect GDP to grow 1.4% in 2017.

ITALY | Municipal elections results point to loss of support for the governing Democratic Party

According to revised data, the Italian economy expanded in Q1 2016. GDP recorded a modest 0.3% expansion, which was up slightly from the Q4 2015 result. While government consumption and fixed investment growth decelerated, private consumption growth was steady at Q4’s 0.3%. The latest high-frequency data paint a mixed picture: industrial production recovered in April while the PMI fell in May. In the wake of the Brexit vote, the government is attempting to shore up the Italian financial sector with a sizeable cash injection designed to mitigate some of the immediate financial risks that have arisen. In the political sphere, Prime Minister Matteo Renzi’s center-left Democratic Party lost both Rome and Turin in 19 June mayoral elections, thus weakening Renzi’s leadership inside the party.

Although domestic demand appears to be gaining traction, the UK’s Brexit vote has presented a number of short- and long-term risks to Italy’s economy. Most of the immediate effect will be limited to the financial side of economy, although political uncertainty in the EU could start to weigh on growth before the end of 2016. Given the volatility following the vote, many analysts are still analyzing the situation and the current forecast is for the Italian economy to expand 1.0% this year, which is unchanged from last month’s forecast. For 2017 the panel sees economic growth picking up to 1.1%.

SPAIN | Congress still fragmented following second round of general elections

Spain’s recovery remained on track in the first quarter of the year as robust domestic demand drove another quarter of solid GDP growth. More recent data for the second quarter paint a slightly dimmer picture: industrial production decelerated in April and the composite PMI deteriorated in May. Despite holding repeat elections on 26 June, political uncertainty appears set to linger in Spain as the results were broadly unchanged from December’s vote. No party won a clear majority, setting the stage for a second round of tough coalition negotiations. On top of this, the most likely options for a coalition government still do not total enough seats to have an absolute majority and this could pave the way for a shaky minority government. Coalition and minority governments are relatively unknown territory for Spain and could threaten reform momentum going forward.

Spain’s growth prospects are stable despite the cloudy political backdrop. An improving labor market should fuel healthy growth this year, but the continued political impasse poses a risk to the outlook. In addition, the recent Brexit vote is casting a cloud over the country’s prospects and is expected to cause heightened volatility in financial markets. Our panelists expect the economy to grow 2.8% in 2016, which is unchanged from the previous month’s estimate. For 2017, the panel sees growth moderating to 2.2%.

INFLATION | CConsumer prices remain in negative territory

Harmonized consumer prices continued to fall in May, declining 0.1% on an annual basis. The result followed April’s 0.2% decrease and comes despite efforts by the European Central Bank to spur inflation. Low energy prices have caused inflation in the Eurozone to linger in what ECB President Mario Draghi called the “danger zone” of below 1.0%.

Inflation is expected to return to the common-currency zone this year, although it will remain meagre overall. Our panel of analysts held their inflation projections unchanged this month. The Consensus view from our panel is that inflation in the Eurozone will average 0.3% in 2016. Looking forward, the majority of analysts agree that inflation will rise gradually and the average forecast for 2017 is 1.4%.

Get the full FocusEconomics Consensus Forecast Euro Area

Written by: Angela Bouzanis, Senior Economist

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