Euro Area: Recovery holds ground in H1 but clouds loom
August 31, 2016
The Eurozone’s recovery lost traction in the second quarter of the year as GDP expanded at the slowest pace seen in two years. Growth came in at 0.3% over the previous quarter, half of the first quarter’s robust 0.6% increase. However, the result was likely influenced by transitory factors—such as the early timing of Easter and a mild winter—which had boosted the first quarter’s result. Overall, the big picture remains bright and GDP in H1 increased a healthy 0.4%, supported by loose monetary policy and an improving labor market.
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While the region’s recovery appears firmly on track, growth patterns within the individual countries were divergent in Q2. France’s economy ground to a halt as labor protests hampered production. Italy’s economy also stagnated, amplifying concerns over the country’s fragile banking sector. A stark contraction in fixed investment dragged on Germany’s growth and renewed apprehension about the pace of investment in the region’s largest economy, although the GDP result still managed to overshoot expectations. On the other side of the spectrum, Spain continued to be one of the region’s top performers as an improving labor market and booming tourism sector fueled economic activity despite political gridlock. Belgium’s economy also recorded strong gains, while GDP contracted at a softer pace in debt-ridden Greece.
It has been over two months since the United Kingdom’s groundbreaking vote to leave the European Union, yet there has been no sign of a major economic shock to the Eurozone’s economy so far. High-frequency indicators have recorded gains in Q3 and suggest that any downturn in growth may be limited in the near-term. Many of the conditions that have driven the recovery remain in place and the FocusEconomics panel sees growth stable in the third quarter at 0.3% over the previous period. Despite these positive signs, optimism post-Brexit is still premature. The brunt of the impact will be felt in the longer term and will depend on what kind of trade arrangement is put into place.
Outside of Brexit, other political developments continue to pose risks to the Eurozone’s outlook and could increase uncertainty in the region. Support for the status quo is waning across a number of countries and the Eurozone’s two largest economies, France and Germany, face key elections next year. Political stability is also at risk in Italy, as 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. Meanwhile, Spain remains in political limbo after two rounds of inconclusive elections, which has delayed the passing of the country’s budget and key reforms.
Beyond elections, elevated security concerns are threatening the region’s tourism sector, while the migrant crisis has provoked tensions between countries. An agreement with Turkey, which has helped stem the flow of people arriving to Europe, has become increasingly shaky and is at risk of collapsing over disagreements between EU leaders and the Turkish President Recep Tyyip Erdogan. Furthermore, high levels of debt are prevalent in many economies, and Greece remains a point of concern. Across the Atlantic, developments in the United States’ political space could have ripple effects on the Eurozone economy through trade and foreign direct investment flows.
Domestic dynamics support stable outlook
Ultra-loose monetary policy, an improving labor market and solid data for the first half of the year are supporting the region’s growth prospects. The FocusEconomics Consensus Forecast panel left their GDP growth forecasts unchanged for the Euro area at 1.5% growth for this year. Next year, the economy is seen slowing to a 1.4% increase as Brexit hampers investment and export flows in the region.
Forecasts for the majority of the economies in the Eurozone were left unchanged, after the numerous downward revisions seen in the previous publication. Analysts held their 2016 GDP projections for 11 of the 19 countries in the region, including major players France, Italy and Spain. The panel revised downwards the forecasts for four countries, while Cyprus, Germany, Greece and Luxembourg were the only economies whose prospects improved.
GERMANY | Investment hampers growth in Q2
Europe’s largest economy lost speed in Q2 when GDP expanded 0.4% quarter-on-quarter, down from Q1’s 0.7% increase. Q2’s downturn partly reflected a normalization in construction activity following Q1’s exceptionally strong performance due to mild weather. Investment in machinery and equipment also fell, heightening concerns that a lack of investment is undermining Germany’s growth prospects and sparking criticism that the government should devote more of its record-high state revenues to the economy to spur investment. Household spending and government consumption slowed down but still remained supportive of growth in Q2, with the external sector performing the strongest. More recent indicators point to robust but unspectacular growth in Q3. Prospects for private consumption have remained upbeat as unemployment stayed at a multi-year low in July and the mood among consumers was very positive heading into September. Developments in the business sphere were less promising: in August, business confidence fell—likely in a lagged reaction to the UK’s Brexit vote—and the composite PMI moderated.
Healthy domestic dynamics will keep Germany on a steady growth track this year and compensate for a weaker external sector, while increased uncertainty about the future shape of the EU represents a downside risk to the outlook. FocusEconomics Consensus Forecast panelists expect GDP to grow at a pace of 1.7% this year, which is up 0.1 percentage points from last month’s forecast. For 2017, panelists forecast a 1.4% expansion.
FRANCE | Strikes hit Q2 GDP
The contentious labor reform bill was enacted into law in August by President François Hollande after months of street protests. Owing in part to disruptions caused by the massive strikes against the labor reform, revised GDP figures showed that the economy grew at a flat rate in annual terms in Q2. The latest economic data suggest that the economy has since lost steam. While the unemployment rate dropped under 10% in Q2 for the first time since 2012 and the PMI expanded in August, consumers remained pessimistic and businesses became gloomier in Q3. A waning economic recovery does not bode well for the beleaguered president. The first potential candidates from his own party have officially announced their presidential bids for next year’s election and have vowed to reverse Hollande’s economic policies and reforms, compounding the uncertainty surrounding fiscal consolidation and economic reforms in the already hotly-contested presidential election.
The government’s labor reforms aim to rekindle growth in the medium term. However, the political backlash and a potential change in leadership at next year’s elections cast doubt on the extent to which this will be achievable, at a time when the outcome of the Brexit vote may also weigh increasingly on economic activity. Analysts expect the economy to expand 1.4% in 2016, which is unchanged from last month’s forecast. Panelists expect GDP to grow 1.2% in 2017
ITALY | Stress tests reveal more banking sector troubles
The economy decelerated further in Q2 on a quarter-on-quarter basis after weak growth in the first quarter. Since then, the latest high-frequency data for Q3 paint a bleak picture: both business and consumer confidence lost ground in August, and in July the PMI weakened, though it remained in expansionary territory. In the latest development regarding the ongoing banking sector instability, Monte dei Paschi di Siena—weighed down by billions of euros in non-performing loans (NPLs)—was found to be heavily undercapitalized in the European Union stress test results released on 29 July. The bank’s board has approved a EUR 5 billion recapitalization plan and the government has sponsored the creation of Atlante 2, a new equity fund set up exclusively to buy Italian banks’ NPLs. Rome is likely to see further pressure on its public finances due to reconstruction costs related to the earthquake that struck central Italy on 24 August, leaving hundreds dead.
Weak domestic and global demand, the ongoing political uncertainty associated with next fall’s constitutional referendum and persistent banking sector-related tensions in the financial markets are weighing on this year’s growth outlook. FocusEconomics panelists expect the Italian economy to expand 0.9% this year, which is unchanged from last month’s forecast. For 2017, the panel also sees economic growth of 0.9%.
SPAIN | Economy remains on healthy footing despite political stalemate
Spain’s economy remained on a solid footing in the second quarter. GDP expanded a seasonally-adjusted 0.8% over the previous quarter, which was in line with Q1’s result and confirmed the economy’s current resilience to the political stalemate that has plagued the country since December. Growth was mainly driven by a surge in exports, which saw the largest increase on record, on the back of larger volumes of goods sold to non-EU countries. In addition, private consumption remained strong, fueled by rising employment, the annual decline in consumer prices and low interest rates. Conversely, government consumption plummeted as infrastructure projects were deferred amid efforts to reduce Spain’s budget deficit. On 9 August, the EU Council waived sanctions on Spain for missing the budget target, and instead set a new 2016 deficit target of 4.6% of GDP, up from the original 2.8%.
Spain’s economic activity will benefit from an improving labor market and favorable financing conditions this year. However, failure to form a government could jeopardize much-needed reforms, while the Brexit vote will gradually weigh on the country’s prospects, especially regarding tourism and exports. 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 2.1%.
INFLATION | Prices pressures pick up in July
Harmonized inflation inched up in July, coming in at 0.2% (June: 0.1%). The reading marked the second month of positive price pressures recorded since January. However, economic slack and low oil prices continue to confine inflation in what ECB President Mario Draghi called the “danger zone” of below 1.0%, despite efforts by the European Central Bank. The lack of price pressures has led some analysts to wonder if monetary policy has reached its limits or if further unconventional measures to stoke prices could be unveiled.
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