Economic Outlook

Eurozone Outlook: Economic Growth Masks Underlying Fragility

Economic recovery is in full swing but investors should remain vigilant of the long-term risks.

The eurozone has finally joined the global growth party. With growth likely to print at 2.3% in 2017, the region has been expanding at a rate well above trend, experiencing the best sustained economic performance in the post-Lehman era. With fiscal policy modestly supportive, monetary stimulus fostering an upturn in the credit cycle, global trade faring well, and pent-up demand being released after many years of meager growth, the upturn has further to run.

At our cyclical forum in December, we forecast real GDP growth of 2%-2.5% for the eurozone in 2018. If anything, recent data point to upside risk to this outlook. At 58.1 in December, the PMI (arguably the best contemporaneous monthly indicator of economic activity) was consistent with growth north of 3% annualized (see Figure 1). In Germany specifically, the headline IFO Institute business climate index in November and December was the highest it has been in the series’ history.

Eurozone PMIs are consistent with growth of around 3%

Growth is not just strong but also synchronized across countries. In addition to Germany, French, Italian and Spanish PMIs have been climbing steadily and signaling well-above-potential growth. The rising tide is lifting all boats, including smaller ones, with the Irish, Portuguese and Cypriot economies recovering briskly, and the Greek economy showing some signs of healing.

Despite the strong upturn, inflation in the region remains depressed as core inflation hovers close to 1% year over year. With its “close to but below 2%” target remaining elusive, the European Central Bank (ECB) is likely to exit its accommodative stance very slowly. ECB asset purchases will be tapered from January, and will probably stop altogether by the end of this year, but policy rates are likely to remain unchanged until around the middle of 2019. This strong stimulative stance should continue to support cyclical growth momentum in the region.

Political risk on the decline in the near term

The improving economy has come alongside a reduction in political risk. The French and Dutch elections in 2017 delivered moderate governments. In Germany, coalition building talks are proving long and difficult but, even if a new election ends up being needed, this is unlikely to significantly change the political status quo. Importantly, electoral polls across the region show a general trend of stabilization or gradual decline in support for anti-establishment parties (see Figure 2), especially after Brexit and the election of President Trump in the U.S. Finally, several anti-establishment parties have been moderating their anti-European rhetoric, having witnessed Marine Le Pen’s failure to secure enough votes with this policy during the French election.