Euro Area: Economic recovery continues in eventful 2016 but more political hurdles loom
December 21, 2016
Despite a year defined by a migrant crisis, populist movements, Brexit and the election of Donald Trump, the Eurozone’s tepid economic recovery continued in 2016. The third estimate for Q3 GDP confirmed that the economy grew a steady 0.3% quarter-on-quarter, which followed Q2’s 0.3% expansion and Q1’s 0.5% increase. The Eurozone’s growth story has remained consistent throughout the year, driven by a strengthening domestic economy while the external sector has been lackluster. Improvements in the labor market, low inflation and ultra-easy monetary policies have boosted growth at home, but investment has yet to fully take off.
Data for the final quarter of the year point to continued gains in the domestic economy. In November, economic sentiment inched up, despite the heightened risk environment, and the composite PMI rested at the highest level in one year in December. Moreover, the unemployment rate fell in October. Leading indicators have yet to show any obvious sign of contagion from 2016’s political shocks and FocusEconomics panelists see growth inching up to 0.4% in Q4.
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Heading into 2017, economic prospects remain encouraging. The recent depreciation of the euro should bode well for the region’s exports. In Italy, steps taken to clean up the banking sector could help solve some of the structural issues in one of the Euro area’s weakest economies and the extension of the European Central Bank’s quantitative easing program ensures that monetary conditions will remain supportive. Yet, 2017 is unlikely to be a year dominated solely by economic events.
A crowded election cycle within the Eurozone combined with unknown policy directions in key trading partners means that political developments will likely rule the narrative going forward. France and Germany, the region’s largest economies and two countries that have been targets of violent attacks in 2016, will hold elections and Eurosceptic candidates are likely to make inroads. In Germany, forming a coalition government is expected to be more difficult, while far-right candidate Marine Le Pen is seen as making it to the second round of the presidential vote in France. Italy is likely to see an early vote, which could take place in 2017, after the resignation of Matteo Renzi this month and the Netherlands will also hold elections.
Outside of the Eurozone, a lack of policy guidance from key trading partners, the United Kingdom and the United States, convolutes the outlook. The UK has yet to give a clear direction on the tone or shape of Brexit negotiations and the new trade agreement will dictate economic implications for the Eurozone. In the U.S., the implications of Donald Trump’s election are hard to decipher, as Trump flip-flopped on many issues. Any enacted protectionist measures could hurt the Euro area’s growth, though stronger activity in the U.S. could also support the Eurozone’s exports. Despite the number of looming unknowns, our panelists see growth in the Eurozone remaining broadly steady at the start of next year and project a 0.4% expansion in Q1 2017 over the previous quarter.
Tepid growth expected in 2017
Growth is seen slowing slightly in the Eurozone in 2017, after coming in at an expected 1.6% in 2016. A rise in inflation will reduced tailwinds to consumption, and investment growth is likely to slow amid heightened uncertainty. However, still easy monetary policy and improvements in the external sector will support only a slight slowdown to 1.5%. The 2017 forecast was raised 0.1 percentage points from last month’s publication. Looking ahead, GDP growth is seen stable at 1.5% in 2018.
Looking at the individual countries in the region, the majority of the economies saw better prospects for 2017 this month. 10 countries had their forecasts upgraded, including Greece, Portugal and Spain. Forecasts were kept the same for major players France, Germany and Italy, along with 6 other economies.
Luxembourg, Ireland and Malta are expected to be the best performing economies in the Eurozone in 2017, with growth rates of over 3.0%. On the flip side, Finland and Italy are expected to be the worst performers with growth rates of near 1.0%. Among the remaining major economies in the region, Spain will grow the fastest at 2.3%—continuing to outperform most of its Eurozone peers—and Germany will expand 1.4%. France is seen growing 1.2%.
GERMANY | Merkel announces intention to run in 2017
The abrupt slowdown in the German economy in Q3 was confirmed by more complete data released by the Statistics Institute in November. Continued strong private consumption growth, which benefitted from record pension increases, strong wage growth and low inflation, was not enough to overcome the negative contribution to growth from net trade. Exports contracted in Q3, brought down by increased uncertainty in the international trading environment. Early data for Q4 paint a mixed picture with consumer confidence and retail sales trending downwards, while business confidence and industrial production stay robust and exports improve. In the political arena, Angela Merkel announced her intention to seek a fourth term as Chancellor in next year’s parliamentary election, which is expected to be closely fought in light of the rise of the far-right AfD party.
GDP growth is expected to turn out softer in 2017, as global uncertainty continues to weigh on Germany’s export sector. As such, domestic demand, supported by a tightening labor market and strong wage growth, should continue to be the main engine of growth. Our panel expects GDP to grow 1.4% in 2017, which is unchanged from last month’s forecast. For 2018, the panel expects GDP growth of 1.6%.
FRANCE | Economy picks up in Q3
Revised data for Q3 confirmed that the French economy recovered modestly from Q2’s contraction. Growth in fixed investment and a positive contribution of inventories more than offset a disappointing performance from the external sector and stagnant private consumption. The latest data suggest that growth will pick up slightly in the last quarter of the year. Industrial production contracted in October while business confidence and the manufacturing PMI soared in December. As the economy languished in 2016, President François Hollande ruled out running for a second term at next year’s highly-contested election. The ever-growing list of presidential candidates offer a range of vastly different policy proposals, ranging from continued protectionism of French industries through to sweeping reforms in an attempt to break the current cycle of anemic growth.
The French economy is expected to grow at a modest pace next year. Higher demand for French goods in overseas markets will be partly offset by weakening domestic demand. Heightened volatility abroad, recurring terrorist threats and the outcome of April’s presidential election are the main risks to growth. Panelists participating in the FocusEconomics Consensus expect the economy to grow 1.2% in 2017, which is unchanged from last month’s forecast. For 2018, the panel foresees 1.4% growth.
ITALY | Gentiloni takes over government
The latest monthly indicators suggest that the economy maintained a slow but broadly steady pace of growth in Q4 after it had accelerated slightly in Q3, mainly on the back of stronger fixed investment, which offset a more negative contribution from the external sector. In the political arena, on 4 December, Italians voted No in the constitutional referendum, prompting Matteo Renzi to resign as prime minister. A lengthy political crisis was nonetheless averted for now as Paolo Gentiloni—of the Democratic Party, like Renzi—was named prime minister and his government was voted in by both houses of parliament. However, the new government faces an immediate challenge as the clock ticks towards a year-end deadline for Monte dei Paschi di Siena, Italy’s third largest bank by assets, to raise EUR 5 billion in capital after the European Central Bank rejected a petition for more time.
In 2017 Italy’s economic growth should broadly mirror this year’s subdued performance, as stronger growth in exports is expected to offset weaker domestic demand. Nevertheless, Italy remains exposed to both internal and external risks: a worsening in the conditions of the banking sector and a weaker global environment represent the main downside risks to growth. Analysts expect the Italian economy to expand 0.8% in 2017, which is unchanged from last month’s forecast. For 2018, the panel sees growth of 1.0%.
SPAIN | Government submits budget amendments
The formation of a government in October, albeit a weak minority one, after ten months of political stalemate finally enabled the drafting of a revised 2017 budget draft that complies with European deficit targets, which the government sent to the European Commission (EC) on 9 December. In addition to optimistic forecasts for higher revenues caused by solid growth, the draft envisages additional measures to plug the budget shortfall, including tax hikes on special items and the removal of several tax breaks for companies. However, it ignores recommendations from both the EC and the IMF to reduce VAT exemptions, since the Spanish authorities are seeking to avoid jeopardizing the consumption-led economic recovery. The budget amendments will now have to be approved in Spain’s fragmented parliament, which is no easy feat. Despite the political uncertainty, however, the Spanish economy has continued to achieve remarkably strong growth this year. In Q3 it posted quarterly growth of 0.7%, just a notch below Q2’s 0.8%. Household consumption continued to support the economy’s performance, which nonetheless suffered from muted investment growth and a drop in exports.
The economy will moderate in 2017 as the beneficial effects of a weak euro and low oil prices dissipate, wage growth remains stagnant and high long-term unemployment and elevated public debt persist. Our panelists expect the economy to grow 2.3% in 2017, which is up 0.1 percentage points from last month’s estimate. For 2018, the panel sees growth easing to 2.1%.
INFLATION | Inflation hits over two-year high in November
Harmonized inflation came in at 0.6% in November, which was above October’s 0.5% and marked the highest reading since April 2014. Inflation has climbed in the past three months as the effect of low energy prices begins to dissipate and stronger economic activity fuels prices. However, it remains in what ECB President Mario Draghi has called the “danger zone” of below 1.0%. This led the European Central Bank to extend its quantitative easing program by nine months at its 8 December meeting, although at a reduced rate of purchases.
Price pressures should pick up through the course of 2017 and our panelists see harmonized inflation of 1.3%, which is unchanged from last month’s forecast. The higher print will be driven by the diminished impact of low energy prices, while economic slack will continue to limit higher inflation. In 2018, inflation is seen rising to 1.5%.
Written by: Angela Bouzanis, Senior Economist