Euro Area Economic Outlook January 2019

Euro Area: Economy slows sharply in Q3; moderate momentum likely persists in Q4

December 20, 2018

Comprehensive data confirmed that growth plunged in the Eurozone economy in the third quarter, recording the softest expansion since Q1 2013. GDP increased a seasonally-adjusted 0.2% over the previous quarter in Q3, below Q1 and Q2’s 0.4% expansions. Growth has dissipated notably after coming in at 0.7% for all of 2017, and the latest reading confirms that the economy has shifted from a recovery boom last year to a slower cruising speed.

The third quarter’s slowdown was broad-based, with deteriorations in both the domestic economy and external sector. Private consumption growth waned as rising inflation ate into household spending, while lower sentiment due to global trade woes and a turbulent political environment dampened investment. In addition, exports contracted, reflecting lower global trade flows and geopolitical uncertainty. On top of this, some one-offs plagued growth in the third quarter. Most notably, new emissions tests hit the automotive industry and caused a stark fall in car production, leading the German economy to contract for the first time in over three years in Q3.

Incoming data for the final quarter of 2018 suggests that the economy’s softer momentum is persisting. Economic sentiment continued to decline in October and November, and the composite PMI fell to an over four-year low in December. That said, the fading of some one-off factors in Q3 should help fuel a small rise in growth, especially the normalization of the automobile sector. FocusEconomics analysts see the Eurozone economy growing 0.4% in Q4.   

In the political arena, developments have been mixed in recent weeks. On a positive note, Germany’s governing CDU elected an ally of Chancellor Angela Merkel as party chief on 7 December, reducing the risk that Merkel—who has been a guiding force in European politics—could lose her job prematurely or face resistance to her policies. However, political stability in the Eurozone’s largest economy is not yet guaranteed and a poor result for either of the parties in the “grand coalition” in 2019’s local or European elections could spark calls for her resignation.

In addition, the Italian government struck a deal with the European Commission (EC) over its’ spend-heavy budget on 19 December. The Italian government agreed to a lower budget deficit target of 2.04% of GDP, compared with the original target of 2.4% of GDP. The new coalition government had been locked in a battle with the EC over its spending plans and uncertainty over the government had seen financing costs soar, weighing on bank lending in the country. However, the reconciliatory tone in recent weeks fueled a rally in bond yields and the two-year bond yield dropped to the lowest levels since the new government took over in December.        

On the flip side, the political and economic situation in France deteriorated starkly in December. The large and violent “yellow vest” protests over fuel tax hikes blocked roads and disrupted economic activity in the month, likely denting growth notably. Moreover, in an effort to calm the situation, President Emmanuel Macron backed down on several reform initiatives and announced a hike in the minimum wage next year. Overall, the protests will likely have a significant short-term economic drag but should be partly offset by next year’s stimulus measures. However, doubt has risen notably over Macron’s ability to continue with his reform agenda.

Some political turbulence was also seen in Belgium this month, after the government lost its majority on 8 December. A junior coalition partner, the New Flemish Alliance, resigned in protest over the UN migration pact, leaving the government with a minority in parliament, which was followed by Prime Minister Charles Michel resignation on 19 December. However, with elections already scheduled for May the resignation will have a muted impact other than bringing the vote forward.

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Growth set to moderate again next year

After GDP expanded a decade high 2.5% in 2017, growth is set to come in at 1.9% this year amid a less favorable external environment and disruptive one-off shocks. Next year, the Eurozone economy is seen decelerating again and growing 1.6%, which is down 0.1 percentage points from last month’s forecast. Faltering economic sentiment, a less dynamic global economy and the normalization of monetary policy are expected to cause growth to return to normal levels after having peaked at the height of the recovery. While a tightening labor market, looser fiscal policy and still-accommodative monetary policy are seen powering growth next year.

That said, risks to the Eurozone’s outlook are clouding the outlook. An increase in global trade tensions, political turmoil or tighter-than-expected financial conditions could dent growth. On the flipside, lower-than-anticipated energy prices, slower ‘normalization’ of monetary policy or dissipating fears over a global trade war could boost the bloc’s prospects. Growth is seen softening slightly to 1.5% in 2020.

Seven of the Eurozone’s economies saw no change in their 2019 forecasts this month including France and Spain. Germany, Italy, the Netherlands and three other economies had their forecasts downgraded, while six economies had their prospects lifted.

GERMANY | Soft data for Q4 comes in; Merkel ally wins CDU party chief

Annegret Kramp-Karrenbauer was elected the new chief of Germany’s Christian Democrats (CDU) on 7 December, replacing Chancellor Angela Merkel as analysts question whether the economy is beginning to show signs of a prolonged loss of steam, or is simply being negatively affected by a conflux of one-off factors. In the third quarter, the economy shrunk for the first time in over two years on the back of weakening domestic demand and a contraction in exports. Additionally, the automotive sector struggled due to new emission regulations, dealing a blow to the economy. Data from the fourth quarter of this year paints a somewhat grim picture. The composite PMI averaged significantly lower in October-November than in the third quarter, while consumer confidence is expected to ease further in December to its lowest level since June 2017. Although business confidence remained in optimistic territory, it moderated for the third consecutive month in December. However, the unemployment rate continued to fall in the same month, while retail sales grew at the strongest clip in over a year in October.

Solid domestic demand driven by a pick-up in public and private expenditure growth should buttress economic activity in 2019. Private consumption will likely benefit from the minimum wage increase from 1 January and a tight labor market. However, uncertainty surrounding Brexit and trade tensions between the EU and the United States cloud the outlook. FocusEconomics Consensus Forecast panelists expect the economy to expand 1.6% in 2019, down 0.1 percentage points from last month’s forecast, and 1.5% in 2020.

FRANCE | Macron unveils stimulus to appease protesters

President Emmanuel Macron delivered a much-watched mea culpa in mid-December as he set out to extinguish the so-called ‘yellow vest’ protests that erupted in response to a proposed fuel-tax hike. In his efforts to mollify protestors, he offered a handful of concessions; raising the minimum wageand slashing some taxes could push next year’s fiscal deficit well beyond the EU-mandated threshold of 3.0% of GDP but appears to have brought the situation under control. Analysts applauded the centrist politician’s resolve to keep alive his reform agenda by introducing sweeteners rather than backtracking entirely on badly-needed labor-market changes, although most acknowledged the president’s weaker footing from here on out. The protests are expected to bruise fourth-quarter economic activity, confirmed by survey-based data for November, and follow the third quarter’s consumption- and investment-driven bump.

FocusEconomics analysts expect recent protests to scatter by next year but continue to pencil in unremarkable, demand-driven growth. Household spending should benefit from income-tax cuts and an improving labor market, while fixed investment—despite the spook in recent weeks—should hold up amid Macron’s reform push, elevated capacity utilization and upbeat economic sentiment. External-sector risks trend to the downside and include a pullback in global trade and any escalation of the U.S.-China trade spat. Meanwhile, next year’s budget has drawn the ire of European lawmakers and could pit the government’s reform push against Brussels’ fiscal-spending rules FocusEconomics analysts see growth at 1.6% in 2019, unchanged from last month’s forecast, and 1.5% in 2020.

ITALY | Government and European Commission strike truce on 2019 budget

Revised data revealed that a fall in domestic demand caused the economy to contract in the third quarter for the first time since the fourth quarter of 2014. The poor showing was led by unrest in financial markets amid the turbulent political situation—which tightened financing conditions and hit business confidence—as well by a modest performance from the labor market. Prospects appear relatively downbeat for Q4: The industrial sector remained weak in October, business confidence continued to decline in October−November and consumer confidence dropped in November, although retail sales regained some steam from the previous month. The negative effects of higher interest rates on the capitalization of the banking system are also constricting credit. The deteriorating economic situation prompted the government to search a compromise agreement with the European Commission over a more responsible target deficit for 2019. The deal, reached on 19 December, reassured investors somewhat, and stops disciplinary procedures against the country.

Growth is expected to be anemic next year. Domestic demand will likely expand at a modest pace, restrained by structural weaknesses, higher interest rates, muted productivity, weak wage growth and slowing job gains due to the implementation of tighter labor laws. Moreover, given the unstable political situation, financial turbulence could resurface, exacerbating the country’s high debt risk profile and problems within the banking system. FocusEconomics panelists project growth of 0.8% in 2019, which is down 0.2 percentage points from last month’s projection, and 0.9% in 2020.

SPAIN | Government loses support in regional election

The economy seems to have maintained momentum in the fourth quarter, following the third quarter’s robust showing which was fueled by a pick-up in consumer spending. A strong rebound in retail sales and a notable acceleration in tourist arrivals in October, coupled with solid readings for the services PMI in October−November, indicate healthy private consumption. Downbeat consumer sentiment in the first two months of the quarter, however, calls for caution. Meanwhile, a mild rebound in industrial production in October and weak PMI readings in October−November point to tepid growth in the manufacturing sector. On the political front, the European Commission expressed concern about the government’s planned increase in spending and skepticism about the viability of current budget targets at the end of November. Furthermore, the ruling Socialist Party’s setback in Andalusian regional elections in early December, together with growing political tensions with Catalan pro-independence parties, pose growing challenges to the party’s political mandate.

Growth is set to decelerate next year due to a slowdown in domestic demand, although it should remain healthy, nonetheless. Fixed investment growth is seen moderating on tightening financing conditions and a softening recovery in the housing market. Meanwhile, slowing employment gains due to lower tourist flows, combined with a minimum wage hike and a possible tightening of the labor code, could weigh on private spending. A sizable fiscal deficit and burdensome public debt also threatens the outlook. FocusEconomics panelists project growth of 2.2% in 2019, which is unchanged from last month’s estimate, and 1.9% in 2020. 

MONETARY SECTOR | Inflation recedes in November; ECB ends QE

Complete data revealed harmonized inflation fell to 1.9% in November, from October’s 2.2%. October’s reading had marked one of the highest readings in the last two years due to higher energy prices. As a result of November’s fall, inflation now lies at the ECB’s target of near, but below, 2.0%.

The ECB kept to its plan and confirmed the end of its massive asset-buying program this month on 13 December. The quantitative easing program has seen the ECB accumulate a portfolio of EUR 2.6 trillion in assets over nearly four years to stimulate the Eurozone’s economic recovery. While the end of QE can be viewed as de facto tightening, the Bank will keep reinvesting the principal payments from maturing securities, which should keep conditions accommodative. In addition, interest rates are expected to remain at their present record-low levels until at least the end of next summer.

Looking forward, inflation is seen receding next year as the base effect from higher oil prices kicks in and growth cools. FocusEconomics panelists see harmonized inflation averaging 1.6% in 2019, which is down 0.1 percentage points from last month’s forecast. In 2020, inflation is seen stable at 1.6%.


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Written by: Angela Bouzanis, Senior Economist

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