Regional slowdown expected in the wake of Brexit
Outside of the UK, the economic damage from the United Kingdom’s vote to leave the EU is expected to be most profound in the Eurozone. In the aftermath of the decision, FocusEconomics panelists have significantly altered their forecasts for the Eurozone economy and many of its constituent countries. Prior to the vote, our panel had considered the region’s recovery to be firmly on track as steady domestic demand had fueled growth in the first quarter of the year and the bloc had showed resilience to external headwinds. Our panelists had projected that economic activity would pick up steam in 2017 and they saw GDP growth remaining broadly steady over the long-term horizon. Now, the Eurozone economy is expected to slow down in 2017 as contagion from Brexit hits the region, and the long-term growth outlook has soured. Our panel sees GDP expanding 1.5% in 2016, which is unchanged from our pre-Brexit forecast, due to a strong first quarter GDP reading and the long timeline for Brexit. Yet in 2017, as the economic consequences take effect, our panel sees growth edging down to 1.4%, which is 0.2 percentage points lower than the pre-Brexit Consensus Forecast.
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Brexit will continue to dominate the headlines in the coming months, sidelining other economic events. 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 the possibility of an extension. Given the complexity of negotiations, discussions are expected to drag out. When the United Kingdom will actually give formal notice remains unknown, though Prime Minister Theresa May has indicated that it will not be before the start of 2017. At this stage it is difficult to fully assess the impact on the region—the outcome of negotiations will be critical—but waves of contagion are expected to hit the region through trade, financial and investment channels in the medium term. In the longer term, Brexit could also fuel political instability in the bloc through possible contagion effects and it will likely have ramifications for migration and the EU budget.
Politics take center stage
The Eurozone economy started 2016 on a high note, growing at the fastest pace seen since Q1 2015. GDP picked up from Q4 2015’s 0.4% expansion over the previous quarter to a robust 0.6% increase in Q1 on the back of firm domestic demand. However, the pick-up in momentum looks to have been short-lived and the FocusEconomics panel expects the economy to have slowed to a 0.3% expansion in Q2. While part of this is due to transitory factors—such as the early timing of Easter—other factors also took a toll on the region’s economy, such as labor disputes in France. In addition, the effects of a number of tailwinds that had been driving the recovery, such as the depreciated euro, have begun to dissipate.
At the start of the third quarter, the region is facing unprecedented political uncertainty. The Brexit vote has thrown the European Union into unchartered territory with massive economic and political ramifications for the bloc and political risks have sharpened in many countries. Spain remains in political limbo despite a second round of elections in June as no political party or likely coalition holds enough seats to form a majority government. In Italy, the upcoming referendum on Senate reform has turned into a de facto vote on Prime Minister Matteo Renzi’s leadership and threatens to unseat the government of one of the Eurozone’s largest economies. Renzi has promised to resign if the referendum fails and the country could see a period of political gridlock akin to that of Spain. Furthermore, across the Eurozone rising Euroscepticism is threatening the political status quo. Austria will face a rerun of presidential elections, which saw only a slim victory over a far-right candidate. While the presidential role is chiefly ceremonial, a win for a far-right party would show growing discontent with the political elite and could fuel further Euroscepticism as well as provoking a backlash on European policies such as immigration.
Meanwhile, Ireland’s Statistical Institute stunned analysts this month when it revised 2015’s GDP growth from 7.8% to a jaw-dropping 26.3%. The figure was attributed to a massive surge in fixed investment and export growth largely due to the country’s success in attracting multi-national companies. While the revised growth numbers show that the country’s deficit and debt dynamics are healthier than previously thought, the figure was due to multiple one-off factors and may not reflect the economy’s underlying growth momentum. In addition, the figure will have ramification affects and Ireland will have to increase its contributions to the European Union budget.
Growth expected to lose steam in 2016
Despite starting the year on a solid footing, growth in the Eurozone economy is expected to moderate this year. After growing 1.6% in 2015, the Consensus Forecast is for 1.5% growth this year, which is unchanged from last month’s projection. Ultra-loose monetary policy and an improving labor market should provide a cushion to the bloc’s economy amid poorer confidence and increased downside risks due to Brexit. Next year, the effects of Brexit will be more pronounced in the region and the Eurozone economy is seen as slowing to a 1.4% increase.
Regarding the economies in the Eurozone, forecasts for almost half of the economies in the region were revised down, partly due to Brexit. Analysts revised down their 2016 GDP projections for 8 of the 19 countries in the region, including major players France and Italy. Meanwhile, analysts’ forecasts were left unchanged for 8 countries including Spain and Germany. The panel revised upwards the forecasts for Cyprus, Finland and Malta.
GERMANY | Brexit drives bonds yields into negative territory
Early signs are pointing to a slowdown in the German economy in Q2, following solid growth in Q1. Exports and industrial production both contracted in May, a month prior to the Brexit vote. More recent indicators have sent mixed signals regarding the impact of the Brexit vote on Germany’s economy. While the Ifo Business Climate Index—one of the first major releases taking into account the UK’s referendum—moderated in July in the wake of the Brexit vote, in the same month the composite PMI increased to its highest level so far this year. Further consequences of the Brexit vote were felt in the financial markets, where the German government issued its first ever 10-year bond with a negative yield, highlighting how growing uncertainty is spurring investors across the continent to purchase safe-haven bonds.
Germany’s economy should grow fairly robustly this year thanks to its solid economic fundamentals and increasingly domestic-demand-led growth. Nevertheless, the heightened uncertainty following the Brexit vote poses downside risks to GDP growth in the coming years as Germany has close economic and financial ties with Britain: it sends some 7% of its exports to the UK and both countries account for large shares of each other’s FDI in- and outflows. The current Consensus Forecast is for GDP to grow at a pace of 1.6% this year, which is unchanged from last month’s forecast. For 2017, panelists forecast a 1.4% expansion.
FRANCE | Government passes labor reform
Following months of strikes against a controversial labor reform bill, the Socialist government passed the law using special constitutional powers to bypass both houses of parliament. The bill, staunchly opposed by labor unions and some members of the governing party, aims to liberalize the highly-rigid labor market. The bill makes it easier to lengthen working hours, reduce severance pay and weaken the unions’ power. Meanwhile, the result of the Brexit referendum is expected to have a limited impact on French confidence indicators and financial markets in the short term, though a decline in exports and investment could weigh on growth in the medium term. The problem of terrorism, however, continues to pose downside risks to the economy. France was struck in mid-July by another deadly terror attack, this time in the major tourist destination of Nice. The recent spate of attacks could have a significant impact on the tourism industry and reduce tourism investment.
While the government’s labor reforms aim to rekindle growth in the medium term, the outcome of the Brexit vote might nevertheless weigh on economic activity. Furthermore, Brexit could fuel Euroscepticism and the threat of recurrent terror attacks could increase political uncertainty ahead of next year’s presidential election. Analysts expect the economy to expand 1.4% in 2016, which is down 0.1 percentage points from last month’s forecast. Panelists expect GDP to grow 1.3% in 2017.
ITALY | Financial market jitters following Brexit hit banking sector
While the economy accelerated slightly in the first quarter, the latest high-frequency data for Q2 suggest that growth remained weak. The UK’s vote to leave the EU prompted high tension in the Italian equity markets, hitting Italy’s most vulnerable banks especially hard and adding to an already serious banking crisis. Italy's third-largest bank by assets, Banca Monte dei Paschi di Siena (BMPS), is in the eye of the storm due to its large stock of non-performing loans (NPLs). Prime Minister Matteo Renzi is trying to organize a government rescue of BMPS to avoid imposing losses on bank depositors and junior bondholders, since that could fuel political discontent ahead of the October constitutional referendum. However, the EU prohibits using public funds for a bank rescue unless bondholders and depositors take their share of the burden. The results of the 29 July stress tests on several banks within the EU will shed light on the Italian banks’ financial needs and might trigger public intervention in support of the bank recapitalization, risking a possible clash with the European authorities.
The re-emergence of tensions in the financial markets and the ongoing weakness in global demand pose downside risks to Italy’s already weak growth prospects. FocusEconomics Consensus Forecast expects the Italian economy to expand 0.9% this year, which is down 0.1 percentage points from last month’s forecast. For 2017 the panel also sees economic growth at 0.9%.
SPAIN | At risk of penalty for breaking EU fiscal rules
Spain’s economy continued to perform well in Q1, even though the expansion was slightly weaker compared to the final quarter of last year. Once again, an acceleration in private consumption was the main factor behind the expansion. Conversely, the external sector faltered and exports swung to contraction. Following two inconclusive general elections in seven months, the country is far from forming a new government. However, the political uncertainty has had little impact on the economy so far. Growth in retail sales decelerated in May, but business conditions in the manufacturing sector improved in June and the PMI hit its highest level in ten months. Nevertheless, Spain’s macroeconomic imbalances remain a concern and the country is at risk of being sanctioned for breaching EU fiscal rules. The European Commission is expected to make a proposal on possible fines by the end of July but will likely postpose its decision on any suspension of structural and investment funds until after the summer.
Spain’s growth prospects are stable despite the cloudy political backdrop. An improving labor market should fuel healthy growth this year. Looking beyond 2016, how Brexit plays out will cast a shadow over the country’s prospects as it could impact Spain’s exports and tourism sector. 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 2.0%
INFLATION | Prices pressures rise slightly in June
Harmonized inflation returned in June, tallying 0.1% (May: -0.1% year-on-year). The reading marked the first increase in prices since January. Despite efforts by the European Central Bank to spur prices higher, low energy prices have caused inflation 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 subdued overall. Inflation projections for the region were 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 1.3%.
Written by: Angela Bouzanis, Senior Economist