What is the outlook for the Eurozone?

Introduction

The uplift in Eurozone economic growth over the past year has been strong, but this has followed numerous years of slow growth since the Global Financial Crisis (GFC) that morphed into a Eurozone debt crisis. There are numerous factors that have been supporting growth. The European Central Bank (ECB) has been running an expanded asset purchase program since 2015, (along with other targeted longer-term refinancing operations), and is currently still purchasing both public and private assets. And interest rates have been cut to zero or even negative for some instruments. The cyclical improvement in the global economy has also benefitted Eurozone exports and domestic activity. New fiscal rules following the debt crisis helped heavily indebted economies to reduce external debt (e.g. Greece, Spain and Ireland) and reign in government deficits. And numerous Eurozone economies ramped up individual structural reforms across product and labour markets to improve productivity and competitiveness.

Although GDP growth and earnings momentum has rebounded, there are question marks as to whether this growth will be sustained and there are numerous Euro-related risks coming up over the next few months to watch for. We look at some of these issues in this Econosights.

What is the outlook for Eurozone growth?

Eurozone growth is currently tracking around 2.1% over the year, a noticeable improvement on ~1% growth three years ago, and at a similar level compared to the US and Australia. Positive data and leading indicators suggest that growth should remain around 2% over 2017-2018.

The five largest countries in the Eurozone are Germany, France, Italy, Spain and the Netherlands, which together account for 75% of the Eurozone’s overall growth. The uplift in Eurozone GDP growth has been broad-based across the major economies (see chart below), but growth in Italy and France have lagged the other major countries.

Similar to the recent experience of other major advanced economies, a decent pick-up in inflation and wages growth has been missing from the Euro growth rebound (see chart below), with headline inflation at 1.3% per annum (the ECB’s target is 2%). Factors driving low inflation across advanced economies include spare capacity, low wages inflation, poor productivity growth and technological changes limiting price rises.

Despite the recent uptick in growth, there is still spare capacity in the Eurozone economy. The unemployment rate is sitting at 9.1%, which has been decreasing over the past few years and is now below the long-run average. But, it still has some room to decline further before it reaches the long-run natural rate of unemployment (around 8.5%). Country-specific labour market reforms have assisted in bringing down unemployment rates (Spain’s unemployment rate has declined significantly from 26% to 17% in three years) but there is still room for reforms to lift

productivity and lower unemployment. High youth unemployment rates are still a problem in the Eurozone. France’s newly elected President Emmanuel Macron has indicated his focus on undertaking labour market reform.

The overall improvement in the labour market has allowed consumer spending to lift. Retail spending growth remains good and sentiment surveys are strong, with confidence around its highest levels since 2000. While wages growth is still low, the strength in GDP growth is positive for the labour market and will eat into some spare capacity, helping to lift wages growth.

Eurozone business surveys (PMIs and surveys around economic sentiment) have been sitting around record high levels for a few months, so further upside is unlikely, but it does indicate continued strength in GDP growth. But one factor still holding back growth is sluggish business investment, an issue faced by many major advanced economies after the GFC as business risk aversion climbed sharply. Machinery and equipment investment growth is improving, but non-residential buildings and structures growth is still weak. Housing construction has risen as house price growth has improved. Businesses may be waiting for signs of a stronger consumer before committing to investment. Stronger business investment is needed to lift the capital stock and productivity growth.

Net export growth has been poor over the past two years, but this masks stronger export and import growth, which reflects the cyclical upswing in the global economy and a better domestic environment. The US and China are the EU’s two largest export groups so solid growth in these two regions will help exports. The currently elevated Euro currency could hinder export growth.

An area of weakness to watch is sluggish momentum in new lending growth for business, consumer credit and housing (see chart below). But the good news is that lending standards are still easy and surveys indicate that banks are still expecting an improvement in demand for business loans, which is a good sign for consumer and business demand ahead.

What else could be done to lift growth in the Eurozone?

Country-specific and broader regional reforms taken after the debt crisis have resulted in improved budget balances and external debt positions. But further reforms (e.g. labour market reforms to increase flexibility, productivity and lower unit labour costs and product market reforms to improve competition, ease regulation and lift incentives for investment) are still necessary to lift growth, particularly across the peripheral Eurozone economies and reform should be adopted while growth is strong. One of the big constraints for Eurozone countries undertaking reforms is adhering to Eurozone fiscal rules. There is likely to be more talk about a Eurozone fiscal union to assist the functioning of the monetary union, particularly given that French President Macron has been speaking about it. There is also further work to be done on the Eurozone banking sector, which is plagued with non-performing loans and poor profitability. Currently, there is pressure on Italian banks to recapitalise, which is expected to occur over the near-term.

Key risks to watch

Any increase in borrowing costs would be harmful for the Eurozone recovery. But, the ECB will not be hiking interest rates for a while, waiting until stronger growth and inflation are firmly entrenched. Markets are expecting that the next ECB meeting (7 September) will see the central bank announce a tapering or reduction of its asset purchase program (currently running at €60bn/month until the end of 2017) for 2018 based on a better growth backdrop and positive rhetoric from the central bank. While some announcement around ECB tapering is likely (because the program runs out at the end of the year), we think that the market has gotten too carried away and taken “tapering” as a sign of “tightening”. The ECB is still going to be running quantitative easing over 2018 – just at a slower pace. ECB interest rate hikes are still some time away. The US Federal Reserve, for example, waited more than a year to hike interest rates after it finished its asset-purchasing program.

Euroscepticism remains an important issue. Soft economic growth since the GFC (despite the latest pick up) and the rise in immigration has made “terrorism” the number one public issue in Europe, according to the Eurobarometer survey, followed by issues of “immigration” and “the economic situation”. However, despite these concerns, the numerous European elections since Brexit (Spain, Austria, the Netherlands, and France) have demonstrated more support for the European Union, perhaps because of the obvious backlash and uncertainty created after the Brexit decision. One exception has been in Italy, which still has some of the lowest support for the Euro area compared to the rest of the region.

An Italian general election will be held before mid-May 2018 and the current polling suggests that support for the Eurosceptic “Five Star Movement” is matching that for the current ruling centre-left Democratic Party. A Five Star Movement victory does not necessarily mean an “Italian Euro Exit” because it may not have a majority in Parliament and it’s doubtful it will be able to form a government or hold a referendum on Euro membership (because of technicalities in the Italian constitution). However, this won’t stop markets from fretting about a Euro break-up, which would hit European equities and the Euro. There is also a German Federal election (24 September), but the risks around this event are low. Polling indicates that Angela Merkel’s party (Christian Democratic Union/Christian Social Union) is expected to win the election comfortably.

Implications for investors

The indicators of Eurozone economic activity remain supportive for solid growth to continue over 2017 and into 2018. Central bank support remains an important part of the economy, which is positive for equities. Our valuation indicators show that Eurozone equities are still cheap, especially compared to US equities, and offer good upside from earnings growth expectations. However, risks around the Italian election should be monitored.