Eurozone Forecast Updates, Q1 2018
Baseline Outlook: the Eurozone boom continues
Eurozone private sector sentiment is at the highest level since the early 2000s, and the unemployment rate has declined to 8.7%, the lowest since early 2009. During the second half of 2017 Eurozone year-on-year GDP growth was 2.7%, compared with long-term trend growth of 1.3%. 2017 GDP growth is now estimated at 2.4%. The domestic economy is booming, but higher exports are also now supporting growth. GDP growth is expected to reach 1.9-2.5% in 2018 and 1.6-2.2% in 2019.
Despite the strong growth in 2017, the Eurozone’s output level is still 10% below the pre-crisis trend, and a large gap relative to the trend is expected to remain over 2018-2019. The positive news is that the global financial and Eurozone crises do not seem to have had a long-term negative effect on the economy’s growth rates.
Estimated baseline forecast probability: 20-30% over a 1-year horizon.
The recent coalition agreement reached in Germany between Angela Merkel’s CDU/CSU and Martin Schultz’s SPD has strengthened the outlook for the Eurozone. SPD members still have to ratify the new agreement in early March. If ratified, the new coalition agreement will likely lead to a looser fiscal stance by Germany and collaboration with France on the creation of a new European investment fund and European Monetary Fund. These developments would improve the Eurozone’s ability to handle future recessions or crises.
Forecast Risks
The main downside risks for the Eurozone economy in 2018 are disorderly bond and stock market declines, and reversals in the current high private sector sentiment. On the upside, better than expected productivity growth, combined with stronger feedback effects between the current optimism, high asset prices and cheap financing conditions could accelerate the economic boom.
In the most likely downside scenario private sector confidence declines significantly, accompanied by a stock market correction of 10-20%, a faster than expected rise in bond yields, and tighter bank lending conditions. GDP growth falls to 1.4-2.0% in 2018 and 0.8-1.4% in 2019.
Estimated scenario probability: 15-25% over a 1-year horizon.
In the most likely upside scenario, labour productivity growth and wage growth exceed expectations. Private sector confidence and financial asset prices continue rising at a similar pace to 2017, boosting consumer spending and investment. As a result, GDP growth rises to 2.4-3.0% in 2018 and 2.3-2.9% in 2019.
Estimated scenario probability: 15-25% over a 1-year horizon.
Political risks remain significant over 2018-2019, though they have declined since 2017. Italian legislative elections in early March are likely to make the anti-Euro M5S the biggest party in parliament. However, the new electoral law adopted in October 2017 makes it extremely unlikely for the M5S to enter government unless it accepts to enter a coalition (which it has refused so far). At the end of January, the 1-year ahead probability of an Italian Eurozone exit was estimated at 5.2%, according to the Sentix investors’ survey.
In the December 2017 Catalan regional elections, pro-independence parties won a majority of legislature seats in, though in terms of popular vote they got 47.5%. The central government in Madrid has made it clear that regardless of the election results, Catalans will not be able to secede from Spain via any referendum without approval by the Spanish parliament. Catalan independence is unlikely, but ongoing tensions and uncertainty could slow down the Spanish economy in 2018.
Aggregate Demand: strong growth expected to continue, but long term financial crisis scars will remain
Eurozone consumption has increased by 1.8% in 2017, sustained by improving labour markets, consumer confidence close to historic highs, and low borrowing costs. Consumption is expected to increase by 1.6-2.2% in 2018 and by 1.4-2.0% in 2019. However, the Eurozone consumption level is still almost 11% below the pre-crisis projected trend.
Eurozone fixed investment has increased by 3.5% in 2017. Business investment continues to be supported by low financing costs, rising profits, lower uncertainty and higher capacity utilisation rates. Business debt burdens have also declined significantly. Fixed investment is expected to grow by 3.1-4.7% in 2018 and by 2-4% in 2019. However, beyond 2019 low expected potential output growth and remaining constraints on bank funding in certain countries are likely to dampen the current recovery in investment. And investment levels are still more than 20% below pre-crisis trend projections.
Private Sector Sentiment and Labour Markets: high optimism and increasing employment, tempered by low wage growth
Eurozone economic sentiment and business climate indices fell slightly in January. However, consumer confidence continued to increase, and all sentiment indices remain close to historical highs.
Employment growth has remained close to 2%, and employment levels are now 1.2% above the pre-crisis peak from Q1 2008. Looking at more robust measures, the Eurozone’s 25-54 year olds employment rate is also close to its pre-crisis level, having recovered around 80% of the decline since 2008.
The unemployment rate has declined to 8.7% at the end of 2017, down from 9.7% at the end of 2016. A growing proportion of Eurozone firms are reporting difficulties in finding skilled workers. Looking across the main Eurozone economies, unemployment rates range from 3.6% in Germany and 9.2% in France, to 10.8% in Italy and 16.4% in Spain. Unemployment is also much higher in certain segments. Youth unemployment rates are still 32.2% in Italy and 36.8% in Spain. There are some concerns about job quality, with most of the newly created jobs in Italy and Spain being temporary or fixed-term. While employment is now above pre-crisis levels, the total number of hours worked is still 3% below the pre-crisis level, reflecting a shift towards more part-time work.
Wage growth remains weak, close to zero in real terms. Like for the US, this goes against the story of a purely demand driven boom, suggesting a significant role for higher labour supply or lower labour bargaining power shocks. Slow labour productivity growth also contributes significantly to the low wage growth.
Financial Markets: stock markets likely to stabilise despite recent decline, interest rates likely to rise gradually
During the end of January and first half of February global stock markets declined sharply on concerns of faster than expected central bank interest rate hikes and rising stock price volatility. As of the end of February, Eurozone stock markets (measured by the Euro Stoxx index) have declined by 5% since the peak on January 22. The decline in stocks was preceded by rising bond yields. French and German government 10-year bond yields have now increased by 0.4-0.45 percentage points since December 2017 (as of February 14th).
Despite the strong rally in 2017, stock market prices in the Eurozone have barely recovered their level from 10 years ago. Eurozone stock markets are probably moderately under-valued given current strong earnings conditions, and still have some potential for above-average returns in 2018-2019. The recent decline is therefore not justified based on fundamentals, and it is unlikely to persist.
The ECB has maintained the same policy rates and Quantitative Easing (QE) tapering speed in recent meetings. ECB Financial asset purchases are expected to continue at least until September 2018. Despite the strong economy, we expect a very gradual monetary policy normalisation, with the ECB’s main policy rate (the refinancing rate) staying zero at the end of 2018, rising to 0.4-0.5% at the end of 2019. However, the speed of QE tapering could be accelerated with financial asset purchases finishing earlier than previously expected in 2018. Eurozone interest rates remain close to the lowest level in the last 10 years, and are likely to rise only moderately over 2018-2019.
In our latest report extract, we provide you with an update on our latest macroeconomic forecasts for key economies and what these mean for our predictions for the global economy. Download Global Economic Forecasts: Q1 2018 to stay ahead of risks and opportunities as they emerge on a macroeconomic basis.