The Eurozone’s economy continues to exhibit resilience, suggesting that some concerns of an immediate Brexit-induced shock to growth were overblown. The available data for H2 point to broadly steady growth, suggesting that the recovery remains on track—albeit at a lackluster pace. The FocusEconomics panel of analysts sees GDP having risen 0.3% in Q3 over the previous period, mirroring the growth seen in Q2. Moreover, the Eurozone’s growth story remains broadly unchanged as low inflation, ultra-loose monetary policy and a recovering labor market continue to act as tailwinds to the domestic economy.
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Adding to the positive news for the common-currency bloc, a number of near-term political risks seem to have abated in recent weeks. Following nearly a year of political impasse, Spain is set to form a government and avoid a third general election after the Socialist party voted to abstain from an upcoming confidence vote on 23 October. The abstention will pave the way for Prime Minister Mariano Rajoy to be reelected, ensuring policy continuation and allowing necessary economic reforms to return to the forefront of the government’s agenda. In the U.S., Hillary Clinton’s lead over Donald Trump has surged in recent weeks as the campaign to become the next President of the United States heads into its final stretch. A Trump victory could be damaging for the Eurozone due to the huge degree of uncertainty over his policies as well as his isolationist rhetoric, which would damage trade. Moreover, additional key issues that have plagued the Eurozone over the past year have receded, at least for now. The Greek government’s continued compliance with the bailout has muted risks of a ‘Grexit’, although the country’s debt remains at a worryingly high level. In addition, flows of migrants have receded in recent months, relieving some pressure from European officials.
As the Eurozone faces a period of relative calm, the spotlight has shifted to December and the coming year. Italy will face a critical referendum on Senate reform on 4 December and Prime Minster Matteo Renzi has stated he will resign if the reform fails, which would shake up political stability in one of the largest Eurozone economies. Moreover, recent remarks from UK Prime Minister Theresa May suggest that Brexit negotiations will formally begin next year and point to a “hard” Brexit, which would hamper trade and have significant ramifications on migration and investment in Europe. The difficult task facing policymakers once negotiations begin was underscored by October’s failure to pass a free trade agreement between Canada and the EU—which has been 7 years in the making.
On top of this, the European Central Bank (ECB) signaled that it would decide on the future of its quantitative easing program at its December meeting. The ECB has become stuck in between a rock and a hard place, with limited tools for spurring the economy or price pressures in the Eurozone. The main policy rate for the ECB is at 0.00% and while several central banks have experimented with negative interest rates, they can distort financial markets and by that effect do more harm than good. The quantitative easing program is set to expire in March, though a number of our analysts expect it to be extended to avoid tightening financial conditions while growth momentum is lackluster. However, a scarcity of eligible assets means that the program will need to be modified.
Positive data supports outlook upgrade
The FocusEconomics panel upgraded their GDP growth forecasts for the Euro area this month. Resilient economic data are supporting the upward revision as the economy’s momentum remains steady. Our panel of analysts now see GDP growth of 1.6% this year, which is up 0.1 percentage points from last month’s forecast. Next year, the economy is seen slowing slightly to 1.4%.
Looking at the individual countries in the region, three countries saw upward revisions this month including major-player Germany. Record tax revenues are allowing the German government to lift spending, while households continue to benefit from a number of tailwinds. In contrast, five countries saw their prospects downgraded, including the Baltics and Ireland. Ireland remains one of the countries’ most at risk of negative spillover effects of a “hard” Brexit in the Eurozone. 11 countries saw no change to their GDP forecast this month.
GERMANY | Government approves tax relief measures
Germany likely expanded steadily in Q3 and at the outset of Q4, following Q2’s slowdown to 0.4% quarterly growth. Industrial production and exports rebounded in August, business sentiment strengthened in September and October’s PMI rose. Upbeat consumer sentiment from July through October bodes well for private consumption. In October, the Cabinet approved modest tax breaks worth more than EUR 2.0 billion in 2017 and EUR 6.3 billion per year starting in 2018. Measures include a wider range of personal exemptions on income tax, a small increase in child benefits and a better adjustment of tax rates to inflation. Meanwhile, investors’ confidence has been shaken by emerging concerns about Deutsche Bank’s financial health, following news that the lender could be fined around USD 14 billion by the U.S. Department of Justice. The as yet undetermined exact value of the fine will determine the bank’s potential capital shortfall and how it handles the matter.
Healthy domestic demand will drive another robust expansion this year. Household spending is being fueled by subdued inflation, record-low unemployment and the ECB’s loose monetary policy. Record tax revenues and low interest rates will enable the government to lift spending while achieving another fiscal surplus. By contrast, the external sector will likely be a weak spot this year amid external headwinds. Our panel expects GDP to grow 1.8% this year, which is up 0.1 percentage points from last month’s forecast. For 2017, panelists forecast a 1.4% expansion.
FRANCE | Fiscal targets in jeopardy
After the French economy took a turn for the worse in Q2 and unexpectedly contracted, the latest indicators from the second half of the year suggest that economic activity is gaining traction. Industrial production expanded in August and leading indicators such as business sentiment rose in September. While the manufacturing PMI dropped marginally in October, the reading still pointed to solid expansion in the private sector. The government has presented its last budget before next year’s presidential elections, which strives to support growth and employment while also fulfilling its deficit reduction obligations. The bill ambitiously includes tax cuts for lower-income household and firms as well as increased spending on education, employment and security. To achieve these conflicting objectives, the government hopes GDP growth will reach 1.5% in 2017, but this is higher than the current FocusEconomics Consensus Forecast, putting France’s fiscal compliance in jeopardy.
The contentious labor reform bill approved by the government aims to rekindle growth in the medium term. However, risks to short-term growth are tilted to the downside due to weakening domestic demand, a possible derailment of fiscal consolidation measures ahead of next year’s presidential elections, the ongoing terrorism threat and Brexit-related uncertainty. Analysts expect the economy to expand 1.3% in 2016, which is unchanged from last month’s forecast, before decelerating slightly to 1.2% growth in 2017.
ITALY | Budget envisions wider fiscal deficit
The latest monthly data indicate that the economy gained some steam in the third quarter after the flat result in Q2. In August, industrial production returned to growth after three months of annual decline. In September, the Purchasing Managers’ Index picked up and business confidence advanced slightly, though consumer confidence continued to weaken. On 15 October, Italy’s government approved the country’s draft budget for 2017. The budget, which was sent to the European Commission to get the green light, includes measures such as expanded tax breaks for investments in production machinery, a reduction of the corporate tax rate for small businesses and an increase in public investment. However, it sets a fiscal deficit of 2.3% of GDP for 2017, higher than the 1.8% deficit previously agreed with the Commission.
Economic growth should accelerate somewhat overall this year, but will nevertheless remain anemic, as weakness in domestic demand persists and the country is lagging behind in adopting pro-market reforms. The main downside risks to growth are a further deceleration in global growth and the turmoil that could result from a negative vote in the forthcoming constitutional referendum on 4 December. Analysts expect the Italian economy to expand 0.8% this year, which is unchanged from last month’s forecast. For 2017, the panel also sees growth of 0.8%.
SPAIN | Political impasse set to end
An end to Spain’s nearly year-long political gridlock may be in sight. On 23 October, the center-left PSOE announced its intention to abstain at the confidence vote that caretaker Prime Minister Mariano Rajoy will face before the end of the month. This comes after the resignation of PSOE leader Pedro Sánchez at the start of October, who had systematically refused to let Rajoy take office. Although the Spanish economy has fared exceptionally well despite the impasse, the forming of a government will provide some reassurance to investors and allow the incoming administration to address the necessary reforms the country needs to rein in the fiscal deficit. On 15 October, the caretaker government submitted to the EU authorities a 2017 budget draft that envisages a deficit of 3.6% of GDP next year, which is 0.5 percentage points above the EU target of 3.1%. The new government will need to find additional savings of around EUR 5.0 billion to adjust for the shortfall.
Spain’s economy will end 2016 having achieved a year of strong growth on the back of resilient private consumption and beneficial financing conditions. Our panelists expect the economy to grow 3.0% in 2016, which is unchanged from the previous month’s estimate. However, as the main tailwinds that drove the economy in 2016 fade, the country’s economic performance will moderate. For 2017, the panel sees growth easing to 2.2%.
INFLATION | Inflation hits over two-year high
Harmonized inflation came in at 0.4% in September, which was above August’s 0.2% and marked the highest reading since June 2014. Despite the rise, inflation remains in what ECB President Mario Draghi has called the “danger zone” of below 1.0% due to low oil prices and economic slack. Despite meagre price pressures, the ECB made no change to its monetary policy in October.
Price pressures are expected to be weak throughout the remainder of this year and our panel sees inflation averaging 0.2% in 2016. The forecast is down 0.1 percentage points from last month’s prediction. Looking forward, the majority of analysts agree that inflation will rise gradually and the average forecast for 2017 is 1.3%.
Written by: Angela Bouzanis, Senior Economist