Eurozone: Consumers to the rescue Global Economic Outlook, Q2 2015
The economic outlook for the Eurozone economy is torn between two poles: better-than-expected performance of the real economy vs. growing doubt about the integrity of the Eurozone.
The economic outlook for the Eurozone economy is torn between two poles. On the one hand, the real economy has been developing better than expected in the first months of 2015. There are encouraging signs pointing to a broader-based recovery than anticipated, while stock markets have been bullish. On the other hand, doubts about the integrity of the Eurozone have reemerged due to difficult negotiations between Greece and the Eurozone about the extension of the existing loan arrangements.
Cyclical support for the recovery
Expectations for the Eurozone recovery are more positive than they were at the end of 2014. One sign is that the Euro Stoxx 50, the index of the 50 most important Eurozone companies, has risen by more than 15 percent between January and mid-March. The brighter outlook for the real economy owes much to supporting external conditions, including:
- Substantially falling energy prices
- An ever-looser monetary policy due to the quantitative easing program of the European Central Bank (ECB) contributing to a weaker euro
- Bank lending to the private sector that is gradually improving
The sharp drop in energy prices since mid-2014 has had a significant impact on the Eurozone economy: increased margins for companies, and—even more significant—an increase in the real disposable income of households, for whom lower energy costs resemble a substantial tax cut.
The brighter consumer sentiment is mostly due to the lower energy prices, but it is also supported by developments in the labor market.
The ECB’s quantitative easing program started in March. By purchasing securities every month worth 60 billion euros, the program intends to reduce borrowing costs and bond yields in order to encourage corporate investments. The effect on bond yields is clear: The yield on German 10-year bonds stood at a record low of 0.18 percent in mid-March, while French bonds yielded 0.45 percent. This is a huge difference between the corresponding US yields of 1.97 percent. Even Spanish and Italian yields are substantially lower than those of the United States, reflecting the effects of the ECB’s massive monetary easing.
While the effects of the program on the real economy remain controversial, the program has undoubtedly helped to push the euro-dollar exchange rate lower and support the export sector, especially given that US monetary policy is set for interest rate increases. In fact, in mid-March, the euro-dollar exchange rate fell to its lowest level in the last 12 years. Moreover, the credit cycle seems to be turning, and lending standards have eased, while lending to the private sector is increasing.
Consumption drives growth . . .
The main factors driving Eurozone growth, whose rate was 0.3 percent in the last quarter of 2014, were household spending and exports. While last year the hope for a Eurozone recovery rested almost exclusively on exports, consumers now have become the main driving force. There are positive signs from household spending, real income, and consumer sentiment. In February, the consumer component of the European Commission’s Economic Sentiment Index reached its highest value since September 2007 (figure 1).
The brighter consumer sentiment is mostly due to the lower energy prices, but it is also supported by developments in the labor market. Although unemployment is still high, it is trending down. Between January 2014 and January 2015, unemployment in the Eurozone decreased from 11.8 percent to 11.2 percent.
. . . In the former crisis countries . . .
This downward trend is particularly visible in the former crisis countries that are now recovering: Spain, Ireland, and Portugal have undertaken significant structural reforms that have improved their public finances and strengthened their competitiveness and exports. All three countries have been able to decrease their unemployment rate by around two percentage points, with a strong impact on consumer sentiment (figure 1).
The recovery process underway started with exports. In Spain, export growth led to a consumption recovery and finally to higher investment activity (figure 2). As a result, the labor market is recovering, and job creation in the first quarter is expected to accelerate substantially.1
. . . And in Germany
In Germany as well, economic growth is currently primarily based on consumer spending. Driven by very low unemployment and an upward trend in disposable income, private consumption was the key driver of overall growth in Germany in 2014 (figure 3). For 2015, it is likely that consumption will again drive growth because of two main factors.
First, wage growth is set to accelerate as the labor market becomes increasingly tight and employees become a scarce resource. The pace-setting wage agreement in the metal and electrical industry, which sets the benchmark for the collective bargaining rounds, ended with a 3.4 percent pay rise. Coupled with low inflation, this is likely to result in further growth of disposable income. Second, because investment behavior in Germany is heavily biased toward fixed interest securities, we can expect that, in the current low-interest environment, much of this additional income will be used for consumption.
A positive scenario
The external tailwinds for the Eurozone economy and the brighter outlook do not mean that the growth-inhibiting factors that accounted for the sluggish recovery over the last two years have suddenly disappeared. There is still the crisis legacy in the form of high public and private debt as well as structural rigidities. However, it does mean that, within these constraints, the recovery has gained momentum and strength.
In a positive scenario, the current trends would continue, merge, and increasingly trespass into investment activity, the sorrow child of the Eurozone economy. If consumption continues to grow and exports to thrive due to the weak euro, it should have in impact on investment activity. If companies reach the limits of their sparse capacity and benefit from low interest rates and higher credit availability, capital spending is likely to increase, which would give the recovery further impetus and a stronger base.
Risks: The return of the Euro crisis
The main risks to this positive scenario are, apart from the ever-present possibility of an escalation in the Ukraine conflict, reemerging doubts about the future of the Eurozone. The relative calm about the Euro crisis in the last two years has come to an end. After a new Greek government came into power, many rifts have emerged between Greece and the rest of the Eurozone.
A shared understanding of the conditions of the bailout program and the necessity of reforms seems to be a long way off. There are several Greek payment deadlines ahead, starting in April, for which the Greek government likely needs financial assistance. Without it, Greece will not be able to pay its ordinary state expenditures, especially salaries and pensions, and it will have to default on its existing debt, which will likely result in an exit from the Eurozone.
Investor surveys show that the probability of Greece’s exit has risen substantially between January and February. At the same time, the risk that a possible “Grexit” would infect other countries is decreasing, according to investors.2 The reasons why a Grexit does not arouse the same fears as a few years ago have to do with the Eurozone’s stronger institutional underpinnings due to the banking union, the European Stability Mechanism, and the much lower exposure of European banks to Greek debt.
Nevertheless, financial contagion cannot be completely ruled out, and an uncontrolled exit by Greece from the Eurozone, either by accident or design, would very likely push the Eurozone back into recession, at least temporarily. Without a Grexit, the recovery in the Eurozone promises to gain momentum.
Investor surveys show that the probability of Greece’s exit has risen substantially between January and February.