Euro Area: Politics takes center stage, but economic backdrop remains encouraging
March 26, 2018
Detailed data for the fourth quarter of 2017 confirmed that the Eurozone economy continued to expand robustly, although growth moderated slightly from the previous quarter. GDP increased a seasonally-adjusted 0.6% over the previous quarter in Q4, a notch below Q3’s 0.7% rise. The domestic economy broadly kept pace, supported by rebounding investment and tightening labor market conditions, while export growth was brisk amid healthy global growth.
Estonia, Slovenia and Lithuania were the region’s star performers in the final quarter of last year, recording the quickest growth rates as flourishing investment and thriving exports helped support the small economies. Ireland was also among the region’s top performers in Q4; however, when examining GDP rates, the headline figure presents a skewed picture, as multinational firms distort the data. At the other end of the spectrum, Greece posted a weak expansion, as the economy remains weighed down by high unemployment and a large debt load. Regarding the region’s major economies, growth dipped in Germany and Italy, but remained unchanged in Spain. Activity gained steam in France.
Available data for the first quarter of 2018 suggests that the economic backdrop remains broadly favorable, although the political scene has become more turbulent in recent weeks following Italy’s 4 March elections and two resignations by leaders in Central Europe. Italy’s vote resulted in a fragmented parliament, with no party winning enough seats to form a majority and anti-establishment parties gained over half of parliamentary seats. As a result, the country will likely face a period of prolonged political uncertainty and tough negotiations to form a government. Moreover, the results of the vote have rendered the outlook for much-needed structural economic reforms bleak; it appears unlikely that there will be the political willpower to pursue such measures.
In Central Europe, Slovakia and Slovenia’s prime ministers resigned within a day of each other in mid-March. Slovakia’s Prime Minister Robert Fico quit following large-scale protests over corruption trigged by a journalist’s murder. However, the crisis was quickly contained, as a new government has already been formed by the ruling Direction – Social Democracy party, with economic policy likely to be unaffected. Meanwhile, Slovenia’s Prime Minister Miro Cerar resigned amid a wave of strikes and the Supreme Court’s decision to annul September’s referendum on a large infrastructure project. The country was scheduled to head to the polls in June, but the latest developments could see the vote moved forward.
Outside of the Eurozone’s domestic politics, developments have been mixed. Major progress was made in Brexit talks between the European Union and the United Kingdom, with a draft withdrawal agreement reached on 19 March. While the agreement is a step in the right direction towards a smooth exit for the U.K., several questions remain, specifically over the future trading relationship and the Irish border.
Developments with the bloc’s other major trading partner, the United States, have been less rosy in recent weeks. Global uncertainty has risen dramatically over fears of a trade war, although for now the Eurozone appears relatively unaffected. On 23 March, the U.S. government announced that exports from the EU would be temporarily exempted from tariffs on aluminum and steel imports until 1 May, but discussions on the topic are ongoing. However, the Trump administration announced a set of punitive actions against China on 22 March, setting the stage to escalate tensions between the two global economic powerhouses. A global tit-for-tat tariff battle could dent confidence and economic activity.
Eurozone’s growth outlook lifted for sixth month in a row
Despite an uncertain political stage, the FocusEconomics panel lifted the Eurozone’s 2018 GDP forecast for a sixth consecutive month in March. The economy appears to be on steady footing, supported by favorable financial conditions, healthy labor markets and buoyant global growth. Although rising trade protectionism or a fiscally irresponsible Italian government remain risks to the common-currency bloc’s outlook, for now these factors seem unlikely to derail the recovery. FocusEconomics analysts see GDP growing a robust 2.4% in 2018, up 0.1 percentage points from last month’s projection. In 2019, growth is seen moderating to 1.9%.
This month, eight of the Euro area economies experienced an upgrade to their GDP forecasts for 2018, including Estonia, Ireland and Slovenia. A strong end to 2017, along with the robust global backdrop, has helped spark upward revisions. No economy saw their forecast revised down, while 11 countries saw no changes to their outlooks.
Ireland and Malta are forecast to be the fastest-growing economies in the region this year, expanding 4.4% and 4.5%, respectively. Conversely, Italy will be the region’s slowest economy, expanding a modest 1.5%. Regarding the other major economies in the region, Spain will outperform the rest, with a 2.7% expansion. Germany’s economy is seen increasing 2.4%, followed by France’s at 2.1% growth.
GERMANY | Renewal of Merkel’s grand coalition brings political uncertainty to an end
Angela Merkel was formally re-elected as Chancellor on 14 March, ending an over five-month period of political uncertainty. The coalition deal with the Social Democrats (SPD) encompasses some additional spending measures but is unlikely to alter Germany’s fiscal stance, despite a changing of the guards at the finance ministry. Under the previous “grand coalition”, the economy picked up pace; last year, it grew at the quickest speed since 2011. That momentum should have carried over into 2018. Although available indicators paint a mixed picture, this is chiefly due to seasonal effects. Industrial production and retail sales contracted in January over the prior period, but still showed robust expansion in annual terms. Moreover, the composite PMI and sentiment indicators remained elevated throughout the first quarter, pointing to sustained economic momentum.
The renewal of the grand coalition brought a return to stability, and the coalition’s proposed fiscal stimulus should propel private and government consumption this year. Moreover, wages are likely to grow robustly, boosted by the collective wage agreement for industrial employees in the Baden-Württemberg state, which should have a spillover effect in other states. Fixed investment and external demand are also expected to remain resilient. Downside risks persist due to the strong euro and rising protectionism in the U.S., which is an important export market for German goods. Analysts see GDP expanding 2.4% in 2018, unchanged from last month’s estimate, and 1.9% in 2019.
FRANCE | Macron targets national railway and public service in reform drive
A final estimate confirmed that quarter-on-quarter economic growth in the fourth quarter of 2017 picked up steam compared to the preceding quarter. High business confidence and cheap credit supported growth in fixed investment, while strong overseas demand buoyed the external sector. The latest data, however, suggests that activity cooled slightly in Q1 of this year. Month-on-month industrial production plummeted in January, and consumer and business confidence have weakened since January. Declines in survey-based data could partly reflect growing apprehension over the reform agenda of President Macron’s administration. The president has vowed not to back down in his attempt to reform the highly indebted state-run train operator and the public service, which would collectively result in the downsizing of 120,000 state employees. Labor unions, in turn, have organized massive nationwide strikes from March until June. The stakes are high for the president, since failing to push through these changes would dent his political capital and likely limit the scope of future reforms.
The economy is set to grow at a strong rate in 2018 and 2019 on the back of elevated fixed investment and healthy private consumption. Disruptive strikes could, however, weigh on economic activity in the second quarter of this year. Panelists participating in the FocusEconomics Consensus Forecast expect GDP to grow 2.1% in 2018, which is unchanged from last month’s forecast. For 2019, the panel sees growth of 1.9%.
ITALY | Hung parliament sets stage for long coalition talks
A shroud of political uncertainty has descended on Italy following general elections held on 4 March. The vote resulted in a hung parliament, with no coalition winning an absolute majority and anti-establishment parties gaining over half of parliamentary seats. Given the fragmented political landscape and significant uncertainty, no future scenario can be ruled out, and a prolonged stalemate could negatively affect investor sentiment and weigh on the economy. Separately, available data suggests that the economic recovery, although modest, is underway. In February business and consumer confidence rose, and the manufacturing PMI remained firmly in expansionary territory. However, in January retail sales dipped and the unemployment rate ticked up—even though the number of people employed continued to grow. Meanwhile, the banking sector continued to send encouraging signs: In January the growth rate of corporate lending gained considerable strength, while banks’ net bad debt declined to the lowest value since the end of 2012.
The outcome of political negotiations will significantly influence Italy’s economic prospects, as the formation of a fiscally irresponsible government could weaken already vulnerable public finances. This would generate financial instability, weighing on growth. Despite this downward risk, the economy should continue to expand at a mediocre, but steady, pace this year. FocusEconomics analysts project growth of 1.5%, unchanged from last month, in 2018 and 1.2% in 2019.
SPAIN | Government attempts to pass delayed budget
Comprehensive GDP data confirmed the economy’s robust performance in the final quarter of last year, dispelling concerns of a severe slowdown caused by Catalonia-induced uncertainty. Discretionary household spending benefitted from solid labor conditions and low borrowing costs. Likewise, leading indicators point to a healthy first-quarter outturn. Social Security affiliations—a proxy for employment growth—were upbeat in February after a positive January reading, while the February PMI showed a broad-based improvement in business conditions amid waning political uncertainty. Indeed, noise linked to Catalonia’s attempt at gaining independence has waned in recent months, although the sides are far from reaching a long-term solution. Meanwhile, Spain’s minority government plans to approve the 2018 draft budget on 27 March and submit it to congress a week later, where it still lacks sufficient cross-party support. Approval of the budget had been previously postponed due to backlash from the government’s heavy-handed response to the situation in Catalonia.
A positive outlook for the economy should fuel resilient fixed investment growth, while continued employment gains, accommodative monetary conditions and relatively subdued inflationary pressures should buttress private consumption. The external outlook is similarly encouraging, with healthy global trade flows and higher competitiveness supporting overseas shipments. Catalonia’s protracted conflict, however, remains a source of concern. Our panel sees growth at 2.7% this year, unchanged from last month’s estimate. For 2019, our panelists foresee growth of 2.3%.
MONETARY SECTOR | Inflation falls in February; ECB inches towards monetary policy normalization
Comprehensive data confirmed that harmonized inflation receded in February, falling further below the ECB’s target of just under 2.0%. Inflation fell from January’s 1.3% to 1.1% in February. Despite robust economic momentum, price pressures remain weak, partly due to a strong euro.
At its 8 March monetary policy meeting, the ECB held its main interest rates unchanged once again; however, it tweaked its forward guidance regarding its asset purchasing program. The ECB removed a line stating that it would scale up asset purchases if necessary. The tweak suggests that the Bank is slowly heading towards monetary policy normalization, although policy and forward guidance remains accommodative overall. The Bank’s bond-buying program is slated to end in September, although it reiterated that this could be extended if necessary.
The FocusEconomics panel sees inflation remaining below the ECB’s target and averaging 1.5% in 2018, unchanged from last month’s forecast. For 2019, inflation is seen rising slightly, to 1.6%.
Written by: Angela Bouzanis, Senior Economist