29.09 Weekly Analysis : Stronger than expected growth in the Eurozone

The positive growth phase of the European economy continues at even stronger rates than we had forecast three months ago …..

We have revised up our estimate for 2017 to 2.2%, from 2.1% previously. However, the acceleration phase is now over. Starting in the second half of this year, and until the end of 2019, GDP will grow at less livelier rates, albeit stronger than the trend. The appreciation of the effective exchange rate will not derail the recovery, as it is in part endogenous in nature and is taking place in an economy that is performing better than expected. We confirm our estimate for 2018 at 1.7%.

Already in June, we expressed a more positive view on the outlook for the Eurozone, in part in light of the evolution of the political picture. Over the summer months, macro data confirmed a stronger than expected underlying trend of the economy. From 0.6% growth q/q (2.3% y/y) in 2Q, up from 0.5% q/q (2.1% y/y) at the beginning of the year, GDP is expected to increase by 0.5% q/q in the summer months as well. The European Commission Sentiment Indicator has reached a new high at 113, well above the average of the previous six months (109); instead, the composite PMI dropped by half a point compared to June, although at 56 on average it indicates growth of at least 0.5% q/q (Fig. 2). However, the weak trend of industrial output at the start of 3Q prompts us to confirm our forecast of 0.5% q/q. In light of the indications provided by data, we have revised up again our estimates for 2017, to 2.2% from 2.0%. Recent data and indications would lead us to revise up our GDP growth forecast for 2018 as well, but for the time being we have opted to confirm our June estimates, of 1.7% in 2018 and 1.5% in 2019. 

Given the stronger than expected macro picture, over the summer months the increase in the external value of the euro consolidated (+6% since the beginning of April, Fig. 4). The standard elasticities of the macroeconomic models suggest that a 5% appreciation of the exchange rate holds back GDP growth by 0.4% after one year. However, as Draghi noted in his press conference last September, the intensity of the negative effect of the exchange rate on growth depends on the nature of the shock. If the shock is endogenous, the impact on growth and inflation is blander, as it reflects more solid fundamentals. Furthermore, the transmission of the exchange rate3 to import prices and end prices may have decreased compared to the past, for: 1) structural reasons, mostly tied to the stronger integration of production processes at the global level, and 2) for cyclical reasons: businesses which export to the euro area are probably proving able to keep prices unchanged in the present phase, characterised by strong demand. The integration of production processes, and the high import content of European exports, results in the trend of exports being more influenced by the evolution of global trade than by the exchange rate (Figs. 5 and 6). Undoubtedly, in the present phase the appreciation of the euro is taking place in an economy displaying a stronger than forecast underlying trend, mostly thanks to resilient domestic demand. It should also be considered that the impact of the exchange rate on inflation and growth is not insulated form monetary policy conduct. The ECB could opt for a slower exit from the asset purchase programme (EAPP), extending it until the autumn of 2018. Consequently, the first policy rate hike would not take place before 20194. Therefore, we believe the movement of the exchange rate may weigh on 2018-2019 growth by up to 0.2%, offsetting the stronger than expected underlying trend.

ECB’s monetary policy will continue to act as the main driver of the recovery in the course of next year as well. On 20 June 2017, the European Fiscal Board indicated as adequate a neutral fiscal policy stance for the euro area in 2018, and suggested differentiated policies within the area, which would imply an easing in Germany and the Netherlands. However, the recommendations of the June European Council meeting reasserted that the use of flexibility to stimulate domestic demand is allowed only in respect of MTO targets (structural balance adjustment of 0.5% per year for the countries distant from the target), which suggests a marginally restrictive rather than neutral fiscal policy stance.

One of the characteristics of the present growth cycle, the longest since the introduction of the single currency, is that the recovery is confirmed as widespread throughout the area, and over the next two years the gap between core and peripheral countries should tighten further (Fig.7), which would make the recovery more solid. GDP growth is still being driven largely by domestic demand, which makes it more sustainable. The surprising recovery in global trade (4.7% in 2017) from 1.6% in 2016, has fuelled euro area manufacturing in the course of 2017. However, in the next two years we expect foreign demand addressed to the euro area to stabilise at around 3.5%, broadly in line with the global growth trend. Therefore, exports should slow to 3.5% in 2018, from 4.7% this year, whereas imports will continue to expand at livelier rates. The positive contribution of foreign trade will gradually drop to zero.

The breakdown of domestic demand growth will see a progressive shift in weight from households’ consumption to investments in machinery. Recent data indicate that corporate spending has set out sure-footedly on a more expansive cycle, given the high level of production capacity utilization, the solid financial position of businesses (Fig. 9), the low cost of obtaining financing through bank loans, and more solid demand conditions. Average growth this year (1.7%) will be penalised by the decline at the beginning of the year, whereas we expect an expansion of close to 4.0% in 2018. Activity in the construction sector is also performing better than expected (+0.5% q/q in the spring months, after a surge at the beginning of the year). Our index points to ongoing positive growth in the coming months, of around 1.0% (Fig. 10). In the course of 2017, households’ consumption proved more resilient than expected, growing on average by 0.5% q/q (1.7% y/y), thanks to the accelerating employment (1.6% y/y, from 1.4% y/y in 2016) and wages (1.9% y/y from 1.3% y/y in 1Q), which balanced in part the increase in inflation (1.5% in August from 0.2% in 2016). However, households’ spending is estimated to have peaked (Fig. 11), purchasing power will be further eroded by the rise in inflation to 1.9% in 2019, and the job trend will remain solid (1.3%-1.4%), albeit less so than in 2017 (1.6%). At the same time, wages are unlikely to accelerate markedly from 1.7% y/y in 2Q this year, given the persistent and ample excess supply (Fig. 12).

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