Eurozone: Accelerating recovery in a risky environment Global Economic Outlook, Q2 2017

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The economic situation in the Eurozone appears paradoxical, with continued political risks squaring off against an accelerating economic recovery. The question is whether the decoupling of economics and political risks can continue.


The economic situation in the Eurozone looks paradoxical. On the one hand, quite a few political risks continue to threaten Europe’s political and economic stability. On the other, financial markets seem unaffected by these risks, and the recovery in the Eurozone continues. Indeed, it is even accelerating and gaining strength. So far, neither the risks stemming from Brexit nor the risk of populistic parties gaining power in European countries has had a noticeable effect. The open question is whether the decoupling of economics and political risks can go on in the long term.

Economic situation and outlook

The Eurozone has enjoyed a very positive first part of 2017. The job market recovery is well underway, with the unemployment rate falling to an eight-year-low.1 Deflation, which was seen as the main economic risk for the Eurozone only a year ago and gave rise to a lot of gloomy predictions, has disappeared from the agenda entirely, as inflation rose to 2.0 percent in February.2

The economic situation in the Eurozone looks paradoxical.

At the same time, the mood among businesses continues to improve, indicating that growth could be stronger than expected. The purchasing managers’ index, which indicates positive momentum if values exceed 50, is clearly in positive territory and rising for most of the large Eurozone economies (figure 1).

Purchasing managers’ index

In some countries, especially Germany, the economic situation looks particularly rosy. According to Deloitte Germany’s spring CFO Survey, 96.0 percent of CFOs from large German companies assess the economic situation as good or very good.3 At the same time, they have become much more positive about the situation and the economic outlook for the Eurozone compared with last autumn.

The positive trend in the Eurozone and Germany in particular continues to be driven by consumers. The combination of real wage growth and improving labor markets is at the heart of the recovery. Consequently, how rising inflation will influence household spending is one of the risks to the recovery. At the same time, there is a moderate rise in investment activity, but it still lags substantially behind what could be expected at such an advanced stage of recovery.

Will political risks materialize?

The recovery takes place in a very risky environment. Political risks continue to rise, preoccupying corporates and financial markets. Two risks are of particular importance: Brexit and the further rise of populist and protectionist economic policies.

Political risks continue to rise, preoccupying corporates and financial markets.

Political risk I: Brexit negotiations

The British government finally sent the letter to the European Union, in which it officially declared its intention to exit the European Union according to article 50 of the Treaty on European Union. In the next step, the European Union will determine its negotiation guidelines before formal negotiations can start presumably in June. The negotiations, scheduled for two years according to the provisions of article 50, will need to overcome two hurdles in the early phases of the negotiation.

The first hurdle is about what to negotiate. The European Union intends to resolve first the modalities of the exit and then the future relationship. The United Kingdom intends to do this in parallel, with a focus on the future relationship. The second hurdle is about money. The European Union starts from the premise that the United Kingdom needs to pay its share of ongoing EU projects it has agreed to, and that it needs to fulfill the commitments it entered into while being part of the European Union, such as pensions for EU civil servants. The sums under discussion are of the order of 60 billion euros. Here, also, the views of the UK government differ.

If these initial hurdles can be overcome, there are two questions that will likely determine the negotiations. First, is a new kind of free-trade agreement possible? A comprehensive agreement would need to include services, where the United Kingdom has a comparative advantage. However, services, especially financial services, are only barely regulated in free-trade agreements.

Second, how can the transitory period be managed? It takes usually much longer to conclude free-trade agreements than the two years listed in article 50. Therefore, if a free-trade agreement can be concluded, the period between the end of the official negotiation period and the conclusion of an agreement becomes crucial. To reduce uncertainty and risk to business, this question would actually need to be dealt with right at the beginning of the negotiations.

Political risk II: Spread of populism

Populist parties with protectionist tendencies have gained a foothold within Europe. They form the government in quite a few countries, such as in Eastern and Northern Europe, and are faring well in the polls in other countries. From a corporate perspective, populist and protectionist economic policies are one of the biggest risks in Europe. According to the Deloitte Germany CFO Survey, these economic policies are considered not only likely to materialize but also have the most severe consequences for companies (figure 2).4

Political risk assessment of German corporates

In this context, the elections in France in April and May are crucial to the future of Europe. At the time of writing, the anti-immigration, anti-EU, anti–free-trade party Front National made it to the second round of the presidential elections. While pollsters foresee a defeat for the Front National in the second round, the number of undecided voters is high, and the reliability of election forecasts under discussion after Brexit and the US election in 2016.

As part of its election program, the Front National intends to hold a referendum about France’s exit from the European Union, the so-called “Frexit.” While there are many constitutional hurdles in France for such an exit—such as the need for a change in the constitution, which requires a big parliamentary majority—a French president from the Front National would massively increase the political uncertainty in Europe and threaten the institutional infrastructure of the European Union.

These risks undoubtedly have the potential to disrupt the ongoing recovery. Nevertheless, they also entail upside risks. The resilience of the current recovery has been underestimated. If the more gloomy political scenarios, which would inhibit the recovery, do not materialize, the Eurozone could continue to provide some more positive surprises.