Euro Area Economic Outlook December 2018

Euro Area: Economic Snapshot for the Euro Area

November 21, 2018

Growth drops to five-year low in Q3

Preliminary data revealed that the Eurozone economy slowed notably in the third quarter. GDP grew a seasonally-adjusted 0.2% over the previous quarter in Q3, the worst result since Q1 2013 (Q2: +0.4% quarter-on-quarter). The sharp deceleration is expected to be partly due to one-off shocks, especially as car production in the quarter was disrupted by new emissions tests. That said, the Eurozone economy has clearly entered a slower growth trajectory after the stellar recovery in 2017, as lower global trade and the delayed effect of the euro’s appreciation hamper the external sector, while lower economic sentiment weighs on domestic demand and higher oil prices eat into households’ purchasing power.

Germany’s economy contracted for the first time in over three years in the third quarter, a driving force behind the weak Q3 reading overall. While Germany’s performance this year has been weighed on by a less supportive global economy, the decline in GDP is expected to have been driven by temporary factors, most notably disrupted car production due to new emission testing procedures. Meanwhile, Italy’s economy stagnated in the third quarter, recording zero growth. Weak industrial production, slower EU growth and declining business confidence amid protracted political instability dragged on Italy’s performance. Cyprus, Lithuania, the Netherlands, Portugal and Slovakia also all saw their economies lose some steam in the third quarter from the previous period.

In contrast, France’s economy picked up pace in the third quarter. A recovery in household spending was behind the improved result as a return to normal temperatures and an end to strikes led to higher expenditures on energy and transport, respectively. Meanwhile, Spain’s economy continued to grow solidly, underpinned by a recovering labor market. Austria, Belgium and Latvia all saw GDP growth quicken in Q3, while economic dynamics were unchanged in Finland in Q3. National accounts data is still outstanding for the remaining economies.

The slowdown is expected to be temporary, and FocusEconomics panelists project the Eurozone to expand 0.4% in the final quarter of the year. A tightening labor market and solid investment should fuel healthy growth, although several headwinds to the bloc’s economic trajectory continue to darken the horizon. Political tensions are high within the bloc, with Italy especially in the spotlight after the Italian government refused to capitulate to demands from the EU Commission to amend its expansionary 2019 budget. The country consequently looks set to enter a long battle with the institution, spooking financial markets.

In addition, Brexit uncertainties still linger, despite the European Union finally striking a deal with the UK on the country’s withdrawal on 14 November. The agreement outlines the divorce bill, a political statement on the future relationship as well as a transition period until at least December 2020 to give more time for the two parties to thrash out the future trade arrangement. The transition period can also be extended once if needed and should help give businesses and governments more time to adjust to a change in the relationship after 45 years of marriage. Overall, the agreement would help reduce economic uncertainty over Brexit and boost economic sentiment. Nevertheless, while the deal appears set to be cleared by EU-members, it is uncertain if Prime Minister Theresa May will garner sufficient support for the agreement in the House of Commons.

Against a tough and fractured political backdrop, France and Germany unveiled a joint paper on 16 November, supporting a common Eurozone budget, breathing life into talk of strengthening Eurozone reforms. The budget would be designed to help spur investment, co-finance public spending and encourage reforms in the bloc. While it could help boost growth and faith in the Eurozone if implemented, the plan is likely to meet resistance from many countries and could take years to become a reality.


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Prospects downgraded as momentum wanes

The Eurozone economy’s growth prospects were chopped this month, as weak data pours in for 2018 and headwinds to growth linger. A tough external environment due to global trade tensions and volatile financial markets should provide less support than in years past for the economy, while political troubles over Brexit, Italy’s populist government and Eurozone political fragmentation plague sentiment. That said, an improving labor market and still-accommodative monetary policy should continue to power the recovery onwards. FocusEconomics panelists project GDP to expand 1.7% in 2019, which is down 0.1 percentage points from last month’s forecast. Growth is seen softening slightly to 1.6% in 2020.

Eight economies saw their 2019 forecasts downgraded this month, including France, Germany and Italy. The bulk of the remaining countries saw no changes to their forecasts, while Malta and Portugal were the only economies to have their forecasts upgraded.

Ireland, Malta and Slovakia are projected to be the Eurozone’s fastest growing economies next year, growing above 3.5%. Saddled with high unemployment and low productivity, Italy is expected to be the slowest growing economy by far and is seen expanding just 1.0% in 2019. Among the remaining heavyweights, the Spanish economy is predicted to grow at 2.2%, while Germany is seen expanding 1.7% and France’s economy is seen growing 1.6%.

GERMANY | GDP contracts for the first time in over three years

Chancellor Angela Merkel announced she will step down as CDU-party chief in December and as chancellor when her current term ends in 2021, which could create a power vacuum in the heart of Europe. The news came in the wake of the Bavarian and Hessian state elections in which the ‘grand coalition’ partners lost ground to the opposition and the far-right AfD. Against the backdrop of increasing political turmoil and following a series of disappointing monthly data, national accounts data showed that the economy shrank for the first time in over three years in the third quarter. This was chiefly due to a weaker external sector, which weighed on the economy and likely suffered from trade-related uncertainties and some one-off effects. Meanwhile, domestic demand painted a mixed picture with private consumption decreasing despite elevated consumer confidence and a low unemployment rate. The economy is expected to rebound in the fourth quarter. Business sentiment was robust in October and consumer sentiment remained elevated through November. The composite PMI, furthermore, continued to indicate improved business conditions, although the growth rate remains at a two-year low.

Resilient domestic demand and a pick-up in exports growth should buttress the economy next year. Private consumption is expected to benefit from the minimum wage increase from 1 January. However, a disorderly Brexit and a flare-up in tensions between the EU and the United States remain dark clouds on the horizon. FocusEconomics Consensus Forecast panelists expect the economy to expand 1.7% in 2019, down 0.1 percentage points from last month’s forecast, and 1.6% in 2020.

FRANCE | Activity firms modestly in Q3

Although economic growth notched higher in the third quarter, matching analysts’ expectations, a late-year economic jolt now appears increasingly unrealistic. A weaker-than expected recovery in domestic demand saw household spending rebound on higher expenditures for energy and transport amid the return to normal temperatures and an end to public-transit strikes. Moreover, corporate investment supported upbeat fixed-capital spending and offset a slump in residential investment. On the external front, exports accelerated. Available fourth-quarter data points to similar year-end dynamics: Private-sector gains appeared to stabilize in October, although economic sentiment trended lower. On the political front, Emmanuel Macron’s approval ratings sank lower in November amid cross-country fuel-tax protests and his faltering popularity has increasingly called into question his ability to push through long-overdue economic reforms.

Demand-side gains are expected to support stable, if unremarkable, growth next year. Household spending will benefit from income-tax cuts and an improving labor market, while fixed investment should hold up amid Macron’s reform push, elevated capacity utilization and upbeat economic sentiment. Meanwhile, next year’s budget is set to rein in expenditures and slash taxes in a bid to bolster the flagging economy—although looks set to run up against frustrated European lawmakers. Downside risks include a pullback in global trade and any escalation of the U.S.-China trade spat, either of which would bruise exports. FocusEconomics analysts see growth at 1.6% in 2019, down 0.1 percentage points from last month’s forecast, and 1.5% in 2020.

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ITALY | Government refuses to yield in budget battle

Following over three years of uninterrupted gradual growth, the economy stagnated in the third quarter, owing to muted contributions from both domestic and external demand. Survey-based indicators point to protracted economic weaknesses in the fourth quarter as tensions between the government and the European Commission (EC) escalate. On 13 November, the government returned the budget to the EC essentially unchanged after the Commission demanded spending growth was moderated and the target-deficit narrowed substantially, thus significantly increasing the likelihood that the EC will launch an infringement procedure against the country for breaching EU budgetary rules. On the previous day, Banca Carige—a mid-tier lender rooted in Italy’s northwest—approved recapitalization measures worth EUR 400 million to alleviate its heavy burden of non-performing loans, along the lines required by the ECB in order to avoid financial contagion. On a somewhat more positive note, on 26 October S&P lowered Italy’s outlook to negative but left its rating unchanged, surprising many market analysts on the upside.

The recovery is expected to remain lackluster next year. Higher interest rates and erratic and interventionist government policies will likely weigh on investment decisions, while a marked slowdown in job creation and sluggish wage growth are set to restrain consumer spending growth. Complicating matters further, the risk of financial turbulence resurfacing due to the country’s high debt load and persistent problems within the banking system cloud the outlook. FocusEconomics panelists project growth of 1.0% in 2019, which is down 0.1 percentage points from last month’s projection, and 0.9% in 2020.

SPAIN | Growth stays healthy in Q3

Preliminary GDP data revealed the economy maintained solid momentum in Q3, with quarterly growth considerably above the sluggish Eurozone average. The third-quarter expansion was entirely fueled by domestic demand, which saw private consumption growth bounce back from an over four-year low amid marginal gains in real wages, and capital spending rise at a healthy clip on the back of upbeat investment in capital goods. Meanwhile, the external sector again dragged on overall growth, as total exports contracted for the first time in five years amid a generalized subdued trade environment. Looking ahead, leading data points to a strong start for Q4: In October, economic sentiment recovered after declining for three consecutive months, while the PMI edged higher than the Q3 average on the back improving business conditions in the services sector. In the political arena, the continued difficulty to secure backing from Catalan pro-independence parties over the 2019 budget has significantly increased the possibility that the Socialist minority government will adopt the previous administration’s tighter budget for next year.

The economy is seen losing steam in 2019 largely due to moderating private consumption. External headwinds also cloud the outlook. The tourism boom of recent years, which was fueled by heightened geopolitical risks in rival tourist destinations in the Mediterranean, is finally cooling and is set to drag on employment growth going forward. In addition, the government faces an increased debt service burden as the ECB’s ultra-loose monetary policy approaches its end. 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 edges up again in October

Complete data confirmed harmonized inflation rose to 2.2% in October, above September’s 2.1% and the ECB’s target of near, but below, 2.0%. Although higher energy prices have caused inflation to hover above the Bank’s target since May, inflation should recede next year as the base effect from higher oil prices kicks in.

Despite an onslaught of weak economic data, the ECB stayed the course at its 25 October monetary policy meeting, making no changes to its interest rates nor its plans to halt its asset-buying program at the end of December. Although the end of QE will be viewed as de facto monetary tightening, the ECB intentions to reinvest the principal payments from maturing securities “for an extended period of time” keep monetary conditions accommodative to support economic activity and stoke inflation. Our panel sees the Bank gradually raising the refinancing rate at the end of 2019 and further in 2020.

Meanwhile, inflation is seen remaining moderate both next year and in 2020. FocusEconomics panelists see harmonized inflation averaging 1.7% in 2019, which is unchanged from last month’s forecast. In 2020, inflation is seen broadly stable at 1.6%.

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Written by: Angela Bouzanis, Senior Economist

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