Eurozone: Summer-blue skies for the economy Global Economic Outlook, Q3 2017

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​With the economy recovering faster than anticipated, fears of a fragmentation of the Eurozone seem to have temporarily eased. However, political uncertainty is far from over—much depends on the outcome of the Brexit negotiations and elections in Austria and Italy.

Introduction

Spring and summer 2017 brought good news for the Eurozone. Tensions in the political risk landscape have decreased, and populist parties underperformed in relation to expectations in the key Eurozone countries of the Netherlands and France. In particular, the election of a decidedly pro-EU president in France has eased fears about a fragmentation of the Eurozone.

At the same time and partly as a consequence, the recovery is developing stronger than many analysts believed only a few months ago. Growth forecasts were revised upward, and employment increased by 1.2 million in the last two quarters. Nevertheless, political risks are here to stay. Forthcoming elections in Austria and potentially in Italy will be a new test of Europe’s political stability. Meanwhile, the Brexit negotiations that started on June 19 will be a source of uncertainty as long as a clear direction is not discernable.

Characteristics of the recovery

The recovery in the Eurozone has been ongoing since 2013 but has remained feeble until 2016. Since then, the pace has picked up, especially since last winter. GDP growth in the first quarter increased to 0.6 percent, more than double the US growth in the same period.

From a country perspective, Spain is experiencing the most dynamic recovery among the major Eurozone countries. After growing at slightly more than 3 percent in 2015 and 2016, growth accelerated slightly in the first quarter of 2017. Currently, the main drivers of growth are private demand and corporate investments; exports were the main driver in the early phases of the recovery. Unemployment has fallen from 25.0 percent to a still-high 18.0 percent. The booming tourism industry, which has recorded more than 20 million tourists over the last six years, has played a substantial role in the improved labor market outlook, as has the export industry.1

Spain is experiencing the most dynamic recovery among the major Eurozone countries.

The economic situation in Germany continues to be rosy. The Ifo economic climate index reached its highest value in 26 years in June, while the unemployment rate was the lowest during the same period. The economy grew 0.6 percent in the first quarter of 2017, and analysts expect a similar growth rate for the second quarter. The recovery in Germany has been driven especially by private consumption in the wake of low energy prices, a tight labor market, a booming real estate sector, and increasing disposable income. Growth contributions from exports have been modest due to rising imports, and corporate investments have developed very weakly. Supported by an improvement in industrial sentiment since the beginning of the year, capacity utilization in the German industry has now markedly moved past its long-term average and is currently at a nine-year high, suggesting a need for new investment.2

The pace of economic recovery in Italy and France has been moderate so far, but it is gaining momentum. While both countries grew at around 0.2 percent quarterly between 2014 and 2016, the growth rate in the first three months of 2017 amounted to 0.4 percent. Unemployment in France fell from 10.5 to 9.5 percent in the last two years, and in Italy from 13.0 percent to 11.1 percent. The Italian economy is held back by problems in the banking sector, which are curbing credit growth.3

Further acceleration?

There are some indications that the biggest bottleneck in the further acceleration of the recovery in Europe—corporate investments—is easing. They have lagged far behind expectations and patterns from previous recoveries. However, according to the latest Deloitte European CFO survey of 1,500 European CFOs, the investment propensity of European corporates is on the rise (figure 1).

Investment propensity of European corporates

Overall investment propensity in Europe has almost doubled since last autumn, with a notable jump among French corporates and significant increases in Germany and Spain. Italy recorded a slight decline, but investment intentions remained at a comparatively high level.

This suggests that the recovery stands increasingly on solid ground, becoming broader-based and opening up the possibility that the Eurozone could turn into a pretty robust growth environment.

Political risks: Next round

The next test of the Eurozone’s stability and the reach of populist parties will be in autumn. Snap elections will take place in Austria in mid-October after the governing coalition of Social Democrats and the conservative People’s Party collapsed. Snap elections in Italy are a possibility but not certain. The next regular voting is set to take place in spring 2018. Earlier, elections in autumn seemed almost certain but hinge on a new electoral law that was not passed at the very last minute in June.

The next test of the Eurozone’s stability and the reach of populist parties will be in autumn.

In both countries, populist parties have a fair chance of becoming part of the new government. The Austrian right-wing Freedom Party was narrowly defeated in the presidential elections last autumn and is, according to current polls, the second-strongest party. While polls in Italy are in flux and the populist Five Star Movement suffered defeat in recent municipal elections, it is neck and neck with the governing Democratic Party.

Meanwhile, the Brexit negotiations have finally started, while the official two-year negotiation period had already begun in late March when the United Kingdom submitted its letter of intent to leave the European Union. Until the end of the year, the focus will be on the divorce modalities.

Three topics need to be resolved in the first negotiation phase from the perspective of the European Union, before future relationship modalities can be dealt with: the rights of EU citizens residing in the United Kingdom and vice versa, the border between the Republic of Ireland and Northern Ireland, and the financial obligations of the United Kingdom. The last point, especially, provides ample room for conflict and disagreement, and holds the biggest risk that no consensus can be reached.

The political uncertainties surrounding Brexit and the rise of populist parties will undoubtedly shape economic growth prospects in the medium term. In the short run, the recovery in the Eurozone is very likely to continue, given that it stands on a more solid footing.