Hopes were high a little more than a year ago, after a tremendous 2017, but the euro zone economy has delivered disappointment after disappointment since the start of 2018. In last year’s four quarters, GDP expanded by just 1.1% (including just 0.3% in the second half), down from 2.7% in the four previous quarters. Italy slipped back into a slight recession in the second half, and Germany almost did so. Q1 2019 data has been mixed, indicating prolonged difficulties in the manufacturing sector yet a brighter situation regarding services and consumption.
The economy has been undermined by several factors
Now that some of these shocks are behind us, several factors are pointing to a moderate re-acceleration in growth in the coming quarters, as long as certain serious risk factors do not come into play.
First of all, some of the factors that were highly negative in 2018 are temporary and likely to fade. While the German auto industry faces very serious challenges in the medium and long terms, production should return to normal (if by “normal” we mean overcoming the specific impact of the 2018 changes in standards) by the start of Q2. Similarly, the easing of the Q1 social unrest in France (although it would be premature to say that the crisis is completely over) should mean a rebound in consumer spending.
Moreover, household income in recent quarters has been on a steep upward trajectory, with the impact in real terms likely to be amplified in 2019 by the receding in inflation. Even as bad news was piling up on GDP and other economic indicators, the unemployment rate kept declining (to 7.8% in January 2019 from 8.6% 12 months earlier); employment remained strong, albeit slightly less so (1.3% in the four quarters of 2018 vs. 1.7% in the four quarters of 2017); and, most importantly, wages rose by about another 2% last year. All of these figures should mean an increase in real household consumption far above last year’s 1.2%, while year-on-year inflation recedes rapidly under the the base effects of energy prices (even when assuming a slight increase in oil prices this year).
In addition to solid household income, fiscal stimulus is expected to have a significant impact on growth this year
All in all, fiscal support (as measured by the widening in the primary structural deficit) is likely to amount to about 0.5% of GDP for the euro zone as a whole. As fiscal support is in the form of various measures taken in 2018 in response to each major country’s specific challenges, it will not be as effective as a coordinated stimulus plan. Even so, if we assume a conservative multiplier of a little less than 50%, it should result in an additional 0.2pp of GDP in 2019. However, the effect is likely to fade in 2020, as maintaining such a heavy fiscal boost is not possible under current projections in all countries.
Regarding export momentum, to which the euro zone is far more exposed than the United States (27% of its GDP vs. 13%, goods and services combined), a slowdown as great as the one in 2018 is unlikely. Our baseline scenario does assume a slowdown in the two major economies and export markets of China and the US, but their growth is still likely to remain much stronger than in the euro zone. Most importantly, we believe that tensions are more likely to ease than to worsen (at least on the strictly trade front) between these two countries, and that there will therefore be fewer disruptions and uncertainties in global value chains. Lastly, and unlike the previous year, the very poor 2018 figures could give way to a positive payback, notably via restocking.
However, this baseline scenario does not reflect a number of risk factors, which, if they come to pass, could make economic agents more cautious and thus easily cancel out the expected benefits from both gains in household purchasing power and a stabilisation in foreign demand.
In light of the above, the euro zone’s economic outlook as Q1 2019 draws to a close is, in our view, more positive on the whole than suggested in recent months’ very poor figures. The most likely scenario is a rebound based mainly on household consumption, which itself will be supported by improved resilient job market and fiscal stimulus, and on less negative (while not positive) trends in foreign demand. However, the rebound is likely to remain modest. We forecast GDP growth of 1.2% between Q4 2018 and Q4 2019 and 1.6% during the four quarters of 2020. A return to 2017-like numbers would require a very strong surge in exports – unlikely under current global conditions. Most important, the rebound is exposed to many risks (beginning with Brexit, US protectionism and domestic political uncertainties) on which visibility could be limited over the next few months. What’s more, under a negative scenario, few major instruments of stabilisation seem to be immediately available – the ECB’s rates are already zero or negative; and a coordinated fiscal response would be hard to organise.