Euro Area Economic Outlook November 2018

Euro Area: Economic Snapshot for the Euro Area

October 21, 2018

Italian budget spooks financial markets; softer growth persists in Q3

Incoming data suggests that economic dynamics were little changed in the Eurozone in the third quarter. FocusEconomics estimates that GDP grew a seasonally-adjusted 0.4% over the previous period, which if confirmed, would match the first and second quarter’s results. While economic momentum remained solid bolstered by accommodative monetary policy and a tightening labor market, growth has nearly halved from 2017’s stellar pace due to a less favorable external environment and softer economic sentiment.

Growth is expected to have slowed slightly in Germany, the Netherlands and Portugal in the third quarter. Incoming data point to a weak performance by Germany’s external sector, while business confidence dropped in the Netherlands in the period. On a bright note, activity is expected to have picked up in France, buttressed by lower taxes and a revival in investment. Italy and Spain are both seen as having grown steadily at Q2’s pace, despite political uncertainty in both economies in the quarter.

Against a backdrop of more moderate growth dynamics, the Eurozone has been hit by market turmoil in October, sparked by the Italian budget. On 15 October, the Italian government approved a spend-heavy budget for 2019, which envisions an increase in the fiscal deficit to 2.4% of GDP. The budget, which also includes the partial rollback of some economic reforms, breaks the government’s commitment to narrow the deficit as required by the European Commission (EC)—breaching EU fiscal rules. The EC swiftly rebuked the government’s plans and is expected to ask for formal revisions, while Moody’s also quickly downgraded the country’s credit rating. However, the Italian government appears unlikely to offer major concessions. Concerns that the budget will derail Italy’s finances and the clash with EU authorities sent Italian bond yields soaring to a four-year high and sparked similar spikes in bond yields of countries on the periphery of the Euro area.

Moreover, the likely coming standoff between EU authorities and the third-biggest economy, Italy, highlights the fragile political backdrop in the Eurozone and the struggle for cohesion among European Union members. Rising populism and political fragmentation have made passing economic and political reforms difficult in the region and put meaningful institutional EU reform off the table for now. Regional elections in Germany’s Bavaria in October saw voters reject Chancellor Angela Merkel’s coalition partners, illustrating the fragile government in the region’s largest economy and a further loss of support for traditionally one of the European Union’s biggest strongholds.

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Activity set to moderate next year amid cooler external dynamics

The Eurozone economy is seen cooling going forward, after a robust growth spurt in recent years. Weaker external sector dynamics should cause the recovery to lose momentum as a strong euro and global trade tensions dent exports, while a still solid domestic economy fuels import demand. That said, the outlook is still solid overall as a tightening labor market and accommodative monetary policy buttress growth at home. Politics remains a key risk to the outlook going forward. A disorderly Brexit, fiscal distress in Italy and rising populism all threaten to spook investors and could dent sentiment going forward. FocusEconomics panelists project GDP to expand 1.8% in 2019, which is unchanged from last month’s forecast. Growth is seen softening to 1.6% in 2020.


Ten economies saw no change to their 2019 forecasts this month, including heavyweights France and Germany. Meanwhile, four economies had their growth projections cut, including Portugal and Spain, as prospects have dimmed against a less supportive external backdrop. Cyprus, Ireland, Lithuania, Luxembourg and Slovakia were the only economies to have their forecasts upgraded. 

Ireland, Malta and Slovakia are expected to be the Eurozone’s fastest growing economies next year, with all seen expanding at over 3.5%. Italy is expected to be the slowest growing economy by far, expanding at just 1.1% in 2019. Belgium and France are also seen growing moderately at 1.6% and 1.7%, respectively. Among the remaining heavyweights, the Spanish economy is predicted to grow at 2.2% while Germany is seen expanding 1.8%.

GERMANY | Bavarian elections signal loss of support for government

Short-term political risk increased somewhat in the wake of the Bavarian state election, which saw the Bavarian Christian Social Union (CSU) lose its absolute majority in the regional parliament and the Social Democrats (SPD) garner only single-digit support for the first time in its history. Although the result might lead the CSU to adopt a less belligerent stance towards Angela Merkel, the SPD’s poor showing could swell opposition within the party towards the alliance with Merkel’s Christian Democratic Union (CDU). The election took place against the backdrop of an economy which appeared to perform steadily in the third quarter. The composite PMI averaged higher in Q3 compared to Q2, chiefly due to the services sector. Moreover, business confidence improved in the quarter, while the unemployment rate fell to a new post-reunification low in September. On the other hand, external data disappointed in July–August, with exports falling in month-on-month terms, while retail sales contracted in the same period despite rising wages and still-elevated consumer confidence. Attention will now turn to elections in Hesse on 28 October.

The economy should continue to be buttressed by resilient domestic demand on the back of higher exports and private and public consumption, with private consumption expected to benefit from an increase to the minimum wage. A disorderly Brexit and a pick-up in tensions between the EU and the United States, however, remain key downside risks. FocusEconomics Consensus Forecast panelists expect the economy to expand 1.8% in 2019, unchanged from last month’s forecast, and 1.6% in 2020.

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FRANCE | Macron cuts spending and slashes taxes in 2019 budget

Tepid growth in the first half of the year was confirmed in recent weeks, and available third-quarter proxies have thus far failed to support analysts’ predictions of a pick-up through the remainder of the year. Consumer confidence ended the quarter at a two-year low as inflation ate into purchasing power, offsetting the effects of this year’s improved labor market on household spending. Moreover, survey-based data also showed waning enthusiasm across the private sector, while decelerating industrial output through August hints at loosened capacity and tame fixed-capital spending. Recent political events may produce a new narrative for the coming quarters, however. In late September, the government unveiled 2019’s draft budget, a measured spending plan set to rein-in expenditures and slash taxes in a bid to bolster the flagging economy—and bring the fiscal deficit to 2.8% of GDP. Moreover, following a series of high-level resignations, in mid-October Emmanuel Macron unveiled his new cabinet. The shake-up, which reshuffled some key personnel but left Bruno Le Maire in his post as finance minister, could stave-off a further loss of public support as Macron pushes forward with reforms to unemployment and pension benefits.

FocusEconomics analysts expect roughly stable growth next year as household spending benefits from income-tax cuts and an improving labor market. Fixed investment should hold up amid Macron’s reform push and upbeat economic sentiment, which would help offset a downside-risk pullback in export growth. Analysts see growth at 1.7% in 2019, unchanged from last month’s forecast, and 1.6% in 2020.

ITALY | Coalition abandons fiscal deficit consolidation in 2019 budget

On 17 October the European Commission (EC) rebuked Italy for breaching European deficit rules after the populist coalition submitted a spendthrift 2019 budget on 15 October. Despite vigorous criticism from the EC and a significant increase in bond yields in the aftermath, the budget has outlined raising the target for next year’s fiscal deficit to 2.4% of GDP and includes handouts to the unemployed and pensioners. The clash with European institutions is likely only the beginning of a fiery exchange and could result in the launching of a Significant Deficit Deviation Procedure. To complicate matters, these political tensions and financial volatility come at a time when, according to both hard and survey-based data, the economy looks to have shifted into a lower gear: Consumer spending is being weighed by weak wage dynamics due to stagnating productivity growth, while business investment is being held back by rising interest rates and a mediocre business environment. On the bright side, credit continued to expand—albeit modestly—in Q3, while external demand was solid in July–August.

Growth is set to remain anemic next year, as investment activity will likely be restrained by higher interest rates, while the pace of increase in consumer spending should remain sluggish as employment growth loses steam. The outlook is clouded by possible financial turbulence, which would lead to higher interest rates and thus weigh on the health of the banking system, credit growth and public debt dynamics. Moreover, potential political instability remains on the horizon due to the heterogeneous nature of the governing coalition. FocusEconomics panelists project growth of 1.1% in 2019, unchanged from last month’s projection, and 1.0% in 2020.

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SPAIN | Government unveils 2019 expansionary budget but faces uphill battle for approval

A second release of national accounts data confirmed the economy maintained solid momentum in Q2 on the back of buoyant fixed investment, with growth showing resilience amid the broader Eurozone slowdown. Available data for Q3 hints at slightly moderating activity, however. Although retail sales bounced back in August after contracting in July, it is likely they will grow at a weaker pace on average in Q3 than in Q2, pointing to continued slack in consumer spending. Furthermore, the composite PMI averaged lower in Q3 from the previous quarter, indicating a loss of momentum in business activity. In the political arena, the Socialist minority government unveiled its 2019 draft budget on 15 October. Notably, it relaxes the 2019 fiscal deficit target from 1.3% of GDP presented by the previous administration to 1.8% and outlines higher revenues—to be generated by major tax reforms—and social spending. However, given that chances of parliamentary approval are slim, the 2018 budget is likely to be rolled over.

Growth is expected to moderate next year amid tapering domestic demand. The external tailwinds that helped sustain the recovery in recent years also seem to be morphing into headwinds. The tourism boom has reached its peak and the industry is set to cool, with arrivals expected to be lower already this year, likely dragging on job creation going forward. Moreover, the ECB’s end to its bond-buying program and normalization of interest rates may increase public debt servicing costs. Lastly, higher oil prices could raise the import bill, weakening the country’s external position. FocusEconomics panelists project growth of 2.2% in 2019, down 0.1 percentage points from last month’s estimate, and 1.9% in 2020. 

MONETARY SECTOR | Inflation inches up in September

Complete data confirmed harmonized inflation at 2.1% in September, above the ECB’s target of near, but below, 2.0% (August: 2.0%). Inflation has risen this year chiefly due to higher fuel costs as a result of firm global oil prices. Core inflation, however, remained moderate in the month, suggesting that economic slack remains.

FocusEconomics panelists see inflation remaining broadly stable going forward. While a solid domestic economy should put upward pressure on prices, the ECB is seen gradually tightening rates going forward. Harmonized inflation is seen averaging 1.7% in 2019, which is unchanged from last month’s forecast. In 2020, inflation is seen stable at 1.7%.

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Written by: Angela Bouzanis, Senior Economist

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