The driver of the Eurozone’s recovery, domestic demand, lost traction in the second quarter, causing GDP growth in the common-currency bloc to slow to a two-year low. Detailed data confirm that growth came in at 0.3% over the previous quarter, nearly half of the pace of the first quarter’s expansion (Q1: +0.5% quarter-on-quarter). The slowdown was driven by the domestic side of the economy, while exports were a bright spot, growing at the fastest pace in one year. However, the result was partly due to base effects as Q1 benefitted from the early timing of Easter and a milder winter. In addition, gains from low oil prices began to fade, causing consumer spending to lose steam.
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Data for the third quarter suggest that the economy’s momentum has not picked up and the FocusEconomics panel sees growth stable at 0.3%. While some high frequency indicators have pointed downwards in recent month, a large Brexit-induced shock to the Euro area’s economy has not yet materialized and the recovery is expected to continue, albeit at a meagre pace. Improving labor dynamics should support consumption across the bloc, but previous boons from low oil prices are expected to fade. The FocusEconomics panel sees growth remaining muted and the economy expanding 0.3% in Q4 for the third consecutive quarter.
In the face of a lackluster growth outlook, calls have begun for more fiscal stimulus in the Eurozone. This month, European Central Bank (ECB) President Mario Draghi called on other policy makers at both the national and European levels to do more to spur growth in the Eurozone. Specifically, Draghi advocated the implementation of structural reforms and supportive fiscal policies, as long as they remain in compliance with EU regulations. Draghi’s appeal comes in an environment of ultra-loose monetary policy that has left many analysts wondering if monetary policy has reached its limits. 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. Despite Draghi’s plea, it remains to be seen if governments will loosen their purse strings and spend as attitudes among certain core countries—most notably Germany—lean towards fiscal prudence.
On the political front, the Eurozone is about to enter a crowded election cycle. Political deadlock continues in Spain and the country could face a third round of general elections in one year. Italywill face a critical referendum on Senate reform on 4 December, which has the potential to shake up political stability. Prime Minister Matteo Renzi has stated that he will resign if the reform fails. Looking into 2017, a number of countries face key elections, including major players France and Germany. Support for the status quo is waning across the Eurozone and this could led to shifts in the balance of power in many countries’ governments.
Balanced risks support stable outlook
The FocusEconomics panel left their GDP growth forecasts unchanged for the Euro area at 1.5% for this year. While a number of downside risks are clouding the outlook—such as elevated political uncertainty and concerns over global growth—supportive monetary conditions and an improving labor market continue to support the region’s growth prospects. Next year, the economy is seen slowing to 1.4%.
Looking at the individual countries in the region, divergent growth trends sparked a number of revisions this month. Seven countries saw downward revisions including France and Italy. A poor performance in the second quarter has hurt France’s outlook, while political and banking sector concerns are hampering Italy’s prospects. On the other hand, five countries saw upward revisions this month, including Greece and Spain. Despite a lack of government, Spain’s economy continues to outperform many of its regional peers. Seven countries saw no change to their outlook this month.
GERMANY | Government loses support in regional elections
The German economy slowed to a 0.4% quarterly expansion in Q2, restrained by shrinking fixed investment and construction. Conversely, public and private consumption continued to grow, albeit less than in Q1, and strong net exports were a bright spot. In Q3, Europe’s largest economy likely grew at a broadly stable pace. Unemployment held steady at a record-low level in August and consumer sentiment was upbeat in September, pointing to household spending as a key growth engine. While July’s declines in exports and industrial production and September’s drop in the PMI are signs for caution, September’s jump in business confidence was welcome news. In September, Chancellor Angela Merkel’s Christian Democratic Union party (CDU) suffered important setbacks in two regional elections, losing voters to the populist and right-wing Alternative for Germany party (AfD) over voters’ discontent with Merkel’s migration policy. This development highlights a fragmentation of Germany’s political landscape and increases pressure on Merkel, who will likely announce in December if she will run for a fourth term in next year’s elections.
Growth dynamics in the domestic economy remain intact and will sustain GDP this year. Private consumption is benefiting from low interest rates, muted inflation and a strong labor market. Rising state incomes due to record tax revenues and low interest rates allow the government to boost spending while running a fiscal surplus. However, the external sector is expected to perform poorly in a context of subdued global demand and strong imports. Our panelists expect GDP to grow 1.7% this year, which is unchanged from last month’s forecast. For 2017, panelists forecast a 1.3% expansion.
FRANCE | Data point to pick up in growth in Q3
The French economy took a turn for the worse in Q2 as economic activity was hampered by a series of one-off factors such as massive flooding and months of street protests. The final Q2 GDP reading recorded a 0.1% drop over the previous quarter, which was revised down from the preliminary estimate of a flat growth rate and marked the first contraction in over three years. The disappointing figure puts the economy at the center stage as presidential candidates from the two main centrist parties are gearing up for primary elections in the following months. While the economy waned in the second quarter, the latest data suggest that economic activity is picking up pace: in September, the Manufacturing PMI jumped to a 15-month high and business sentiment improved.
The labor reform bill approved by the government aims to rekindle growth in the medium term. However, weakening domestic demand, uncertainty ahead of next year’s presidential elections, the ongoing terrorism threat and the uncertain outcome of the Brexit negotiations are casting a shadow on the outlook. Analysts expect the economy to expand 1.3% in 2016, which is down 0.1 percentage points from last month’s forecast. Panelists expect GDP to grow 1.2% in 2017.
ITALY | Government announces date for critical referendum
The revised estimates recently published by the Italian National Statistics Office (ISTAT) confirmed that the economy stagnated in the second quarter of 2016. The flat reading represented a deceleration from Q1’s 0.3% expansion and was due to the broad-based weakening of the domestic sector. Conversely, the external sector contributed positively to overall growth since exports expanded at the fastest rate in six years. High frequency indicators from the third quarter hint at another disappointing growth figure, which could also threaten the country’s political stability. On 26 September, the Council of Ministers announced that the key constitutional referendum—on which Prime Minister Matteo Renzi is gambling his political future—will take place on 4 December, after the release of the Q3’s GDP growth rate, expected for 15 November. A mediocre result could turn the electorate against the government-endorsed Yes vote.
The ongoing political uncertainty associated with the upcoming constitutional referendum and persistent banking sector-related tensions in the financial markets are weighing on this year’s growth outlook. Moreover, recent estimates put the damages caused by the 24 August earthquake in Amatrice at more than EUR 4 billion, which will strain Italy’s already struggling public finances. Analysts expect the Italian economy to expand 0.8% this year, which is down 0.1 percentage points from last month’s forecast. For 2017, the panel sees economic growth of 0.9%.
SPAIN | Political stalemate threatens to delay budget
Spain continues to be beset by political uncertainty. Although the country managed in early August to avoid EU fines for repeatedly missing its budget target, failure to submit a 2017 budget draft to the EU authorities before 15 October could trigger a fresh round of sanctions, especially if Brussels deems the efforts to reduce the fiscal deficit to be insufficient. Spain has been unable to present the draft so far since the caretaker minority government does not have enough support to pass measures to address the deficit. In a bid to keep this year’s deficit in check, the interim government is however hoping to achieve a majority in Congress to introduce changes to corporate tax laws, which would raise EUR 6 billion by year-end. Despite Spain’s political and fiscal challenges, economic growth remained unscathed in the first half of the year, with GDP expanding a seasonally-adjusted 0.8% in Q2 over the previous quarter. High frequency data for the third quarter point to a more mixed picture: while the PMI rose in August, industrial production fell markedly in July.
Spain’s economic activity will benefit from an improving labor market and favorable financing conditions this year. Our panelists expect the economy to grow 3.0% in 2016, which is up 0.2 percentage points from the previous month’s estimate. Although growth so far has proven resilient to political shocks, the gradual fading away of the country’s tailwinds and the aftermath of the Brexit vote will weigh on the country’s outlook, especially regarding tourism and exports. For 2017, the panel sees growth easing to 2.1%.
INFLATION | Price pressures stable in August
Harmonized inflation came in at 0.2% in August, matching July’s reading. Economic slack and low oil prices continue to limit inflation in what ECB President Mario Draghi called the “danger zone” of below 1.0%. This had led some analysts to wonder if monetary policy has reached its limits or if further unconventional measures to stoke prices could be unveiled. Despite some calls to extend its quantitative easing program, the ECB made no changes to its monetary policy in September.
Price pressures are expected to be meagre throughout the remainder of this year and our panel sees inflation averaging 0.3% in 2016. The forecast is unchanged 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