Euro Area Economic Outlook July 2018

Euro Area: Economic Snapshot for the Euro Area: Growth cools sharply at the start of 2018

June 25, 2018

Comprehensive GDP data confirmed that growth slid in the Eurozone economy at the start of the year. GDP increased a seasonally-adjusted 0.4% over the previous quarter in Q1, down from Q4 2017’s solid 0.7% rise. A weak performance by the external sector drove the downbeat reading, as exports contracted for the first time since Q4 2012. A slower global recovery and strong euro likely weighed on overseas sales in the quarter. In addition, government spending stalled, while fixed investment growth slowed substantially. That said, several one off-factors also impacted the result negatively, such as the early timing of Easter.


Several of the individual economies in the Euro area saw momentum wane in the first quarter, including regional giants France and Germany. Meanwhile, Italy’s economy grew at a steady pace, underpinned by strengthening household spending, which helped offset a weak external sector. Growth was also unchanged in Spain, as healthy employment growth and low inflation boosted consumer spending. On a positive note, crisis-ridden Greece grew for a fifth consecutive quarter and saw growth accelerate, suggesting that a gradual recovery has taken hold.


While economic growth remains at a solid, albeit more moderate, pace, political challenges are emerging, threatening to weigh on confidence in the common currency area. Italy and Spain have both seen political turbulence in recent weeks, with new, relatively shaky governments installed. In Italy, a government formed by the populist Five Star Movement (M5S) and right-wing League party was instated in June, ending months of deadlock. However, the two parties are unlikely allies, and it remains to be seen how long they will be able to work together. In addition, their coalition agreement spells out plans for fiscally expansionary policies, which could cause the government to clash with European bodies if they do not follow the spending rules.


In Spain, Socialist Pedro Sánchez was sworn in as the new prime minister at the start of June, after Mariano Rajoy lost a confidence motion amid fallout from a massive corruption scandal. The new government has weak political capital, holding only 84 seats out of 350 in parliament, which will constrain policymaking and could limit its tenure in power. Meanwhile, political uncertainty has also increased in Germany due to an internal dispute within the ruling coalition over migration policy. The dispute is jeopardizing Chancellor Angela Merkel’s leadership as Interior Minister Horst Seehofer is threatening to turn away migrants who have registered in another EU country at the border—a move Merkel opposes—unless she can secure an E.U.- wide solution at the end of June summit.


On top of internal political turbulence, growing global trade tensions are also threatening the Eurozone’s outlook. On 22 June, U.S. President Donald Trump threatened to escalate a trade dispute with the European Union by slapping a 20% tariff on automobiles. The statement came after the EU enacted retaliatory tariffs on U.S. goods, following the U.S.’s imposition of tariffs on steel and aluminum. While the U.S.’s initial tariffs on steel and aluminum are expected to have a relatively small economic effect, the automobile industry is a much larger sector and the U.S. is the biggest market for EU car exports, meaning that the economic effect would be much more pronounced if Trump follows through.


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Prospects downgraded following soft Q1


A soft first quarter, rising inflation and mounting political risks led FocusEconomics panelists to downgrade their view of the Eurozone economy this month. GDP is now seen growing 2.2% in 2018, down 0.1 percentage points from last month’s forecast. Rising inflation is likely to take a bite out of household consumption this year, while slowing export growth is also seen dampening momentum. That said, growth is expected to be healthy overall, thanks to falling unemployment and solid investment. In 2019, GDP is seen expanding 1.9%. 


Most of the individual economies surveyed saw no changes to their forecasts this month, including regional heavyweights France and Spain. However, Estonia, Germany and Italy had their forecasts cut, while Austria, Finland and Malta were the only economies to see their growth projections raised.


Ireland and Malta are projected to be the region’s fastest-growing economies this year, expanding 5.4% and 5.1%, respectively. Conversely, Belgium, France, Italy and Greece will be the worst-performing economies, all growing less than 2.0%. Regarding the other major economies in the region, Spain will outperform the rest, with a 2.7% expansion, and Germany is seen growing 2.2%.


GERMANY | Subdued economic data trickles in


The economy continues to stumble against an increasingly uncertain global and domestic political background. First-quarter data disappointed, and available figures for the second quarter continue to be lackluster. At the start of the quarter, industrial production moderated, while retail sales were weak despite record-low unemployment levels continuing into May. Moreover, in the second quarter, the average PMI, consumer confidence and business sentiment readings trended lower compared to the prior quarter. Business confidence deteriorated on the back of pessimistic outlooks on future business conditions amid global and domestic geopolitical tensions. The United States could slap tariffs on European cars, which would especially hit German industry, given Germany’s position as Europe’s leading car manufacturer. Politically, Chancellor Angela Merkel’s coalition looks shaky, as pressure builds over the EU’s migration policies.


Downside risks are building. In the short term, there is notably political uncertainty at home, but in the medium term escalating tensions with the U.S. represent the biggest risk. Despite disappointing monthly data, FocusEconomics Consensus Forecast panelists expect the economy to pick up pace in the remainder of the year and expand 2.2% in 2018, down 0.1 percentage points from last month’s forecast. The economy is expected to be carried by healthy government consumption, private consumption and fixed investment. Strong wage growth should buttress household consumption. Next year, the panel foresees growth of 1.9%.


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FRANCE | Macron pushes on with reform drive


Revised national accounts data confirmed that the French economy decelerated at a faster-than-expected pace in the first quarter of the year. The GDP figure was dragged down by slower growth in fixed investment and exports, and the deceleration put an end to a sequence of five quarters of robust expansion. The latest data from the second quarter shows a diverging picture of the economy, with survey-based data positive but hard data remaining disappointing. Industrial production contracted for the second consecutive month in April, while sentiment in the manufacturing industry remained steady at a high level in June. On the political scene, the senate voted into law on 14 June a bill reforming the state-run train operator. The law, which opens the sector to private competition and cuts employee benefits, represents an important victory for Emmanuel Macron’s economic liberalization reform drive. The government is now planning to sell stakes in public-private enterprises to increase revenue and reduce fiscal spending.


The economy is expected to decelerate this year from 2017’s strong print due to easing growth in both exports and fixed investment. Although private consumption is projected to accelerate, it will be constrained by the increase in inflation and indirect taxes. Prospects of increased protectionism could impact the country’s industrial sector and weigh on business sentiment. Panelists participating in the FocusEconomics Consensus Forecast expect GDP to grow 2.0% in 2018, which is unchanged from last month’s forecast. For 2019, the panel sees growth of 1.9%.


ITALY | New government sworn in


Following three months of political deadlock and two unsuccessful attempts to form a government, on 6 June the Italian Parliament signed off on a government formed by the right-wing League party and the leftist populist Five Star Movement. As the two parties have different ideologies and the coalition agreement is the result of complicated negotiations, governing will not be smooth sailing. The deadlock has been resolved at a time when the recovery seems to have lost some steam. Recent GDP data shows that growth was broadly stable in Q1, but the economy shows some signs of having slowed in Q2, partly affected by subdued growth in the whole eurozone. In April, the industrial sector weakened considerably, and retail sales contracted sharply amid falling consumer confidence. However, NPLs declined further, confirming that the banking sector has indeed turned a corner, and the construction sector rebounded significantly. That said, survey-based indicators deteriorated further in May, a consequence of both weak external demand and the difficult political situation.


Going forward, Italy will navigate in uncharted political territory. Political uncertainty, together with possible financial turbulence, represents the main downside risk to growth, especially in light of the fragility of Italy’s public finances. That said, further improvements in the banking sector should help strengthen business credit and investment, while moderate inflation and employment gains should support consumer spending. FocusEconomics panelists project growth of 1.3% in 2018, down 0.1 percentage points from last month’s forecast, and 1.2% in 2019. 


SPAIN | Change of prime minister unlikely to affect economic momentum


Pedro Sánchez, leader of the Socialist Party (PSOE), was sworn in as prime minister on 2 June following a successful parliamentary vote the previous day on the no-confidence motion he introduced against Mariano Rajoy on 25 May. His new government brings a period of heightened political uncertainty given his party’s minority position, holding just about a quarter of seats, in congress. The economic impact should be limited, however, as Sánchez has committed to applying the recently approved 2018 budget and adhering to EU fiscal rules. The political shake-up came against a positive economic backdrop, with GDP expanding a solid 0.7% quarter-on-quarter in Q1 on the back of stronger gains in private consumption and fixed investment. Going forward, available data points to a slowdown in Q2, however, with growth of both industrial production and retail sales decelerating markedly in April and the manufacturing PMI also losing momentum in April–May.


Strong employment growth and relatively subdued inflation should continue to propel private consumption, underpinning growth this year. However, the economy faces mounting headwinds in the short-to-medium term. The key tourism sector, which has experienced a boom in recent years largely a result of surging geopolitical risks in other tourist destinations in the Mediterranean, is showing signs of cooling. Moreover, given Spain’s high energy import dependence, rising oil prices should exert upward pressure on the import bill, likely dragging on growth going forward. FocusEconomics panelists project growth of 2.7% in 2018, unchanged from last month’s estimate, and 2.3% in 2019.


MONETARY SECTOR | Inflation jumps in May


Comprehensive data confirmed that harmonized inflation rose in May, coming in line with the ECB’s target of just under 2.0%. Inflation increased to 1.9% in May, the highest reading since April 2017 (April: 1.3%). Rising energy prices largely drove the result.


Rising price pressures and a firm economic recovery led the ECB to announce the end of its massive monetary policy stimulus program at its 14 June meeting. The ECB will end its asset purchases program at the end of December and halve the pace of purchases in the final quarter of the year. On top of the announcement, the ECB also gave clearer forward guidance on the path of interest rates going forward, stating that interest rates will remain at their current low levels through the summer of 2019.


The FocusEconomics panel sees inflation averaging 1.6% in 2018, up 0.1 percentage points from last month’s forecast. For 2019, inflation is seen stable at 1.6%.


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Written by: Angela Bouzanis, Senior Economist


 

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