The eurozone - destined to disappoint?
The optimism of 2017, when a global synchronised recovery helped growth in the eurozone reach a 10-year high of 2.4%, seems like a distant memory. In 2018, growth in the region slowed to 1.8%, with Italy entering a technical recession during the second half of the year, and Germany avoiding the same fate by only the narrowest of margins.
Admittedly, part of last year’s slowdown was the result of transitory factors. German manufacturing was disrupted by the introduction of new vehicle emissions tests. In addition, low water levels on the Rhine hampered the transportation of both raw materials and finished goods. The “gilets jaunes” protests hit activity in France, and a row over the budget between Italy’s populist government and the European Commission took its toll on both financial markets and business sentiment.
However, recent experience has provided a reminder that the region’s fortunes are closely tied to trends in global trade. The eurozone is an open economy, with exports of goods and services making up around 48% of GDP, nearly four times that in the US. This has left the region vulnerable to the recent deceleration in global growth. The US-China trade spat has accentuated the structural slowdown in the Chinese economy (see our January 2019 commentary), while also undermining global business sentiment and investment spending, creating a headwind for exporters of capital goods. Falling Chinese car sales have also hit European car manufacturers hard.
Moreover, as the external environment for eurozone businesses became more challenging through last year, consumers in the region failed to pick up the slack. Despite falling unemployment and a pick-up in wage growth, consumer confidence deteriorated in tandem with business sentiment. As a result, households chose to save more of their increased income rather than go on a spending spree.
Signs of stabilisation
So, what is the outlook for the region in 2019? The economic data is starting to show tentative signs of stabilisation, as transitory headwinds ease. Following sharp falls through 2018, the region’s composite PMI – a measure of activity across the manufacturing, construction and services sectors – rose to a 3-month high in February. Both industrial output and retail sales in the region posted solid monthly gains in January.
Moreover, the introduction of further stimulus measures in China has raised hopes that the slowdown in the world’s second largest economy will soon bottom out, easing the drag on eurozone exporters. A dovish pivot on the part of the US Federal Reserve (see our February 2019 commentary), along with hopes for a US-China trade-deal have lifted global equity markets and loosened financial conditions in recent months, which could usher in an improvement in economic sentiment and activity.
However, the region still faces considerable threats going forward. Although a disorderly Brexit would do proportionately more damage to the UK, it would still have a considerable negative impact on the eurozone economy. Concerns over the sustainability of Italy’s public finances are also likely to resurface at some stage.
In addition, with current trade talks between the US and the EU currently gridlocked, there is a risk that President Trump will follow through on his threat to impose a 25% tariff on European car imports. Some EU leaders are concerned that an eventual US-China trade deal could see Beijing favouring US companies over their European counterparts (e.g. buying planes from Boeing rather than Airbus).
What’s more, the global economic cycle is unlikely to provide any great relief. Although the Chinese authorities are attempting to manage the country’s slowdown, the official 2019 growth target of 6.0-6.5%, down from the 6.6% rate recorded in 2018, suggests a renewed upswing is not on the cards. Growth in the US economy is also on course to soften from the 2018 pace of 2.9%, as the boost from the Trump tax cuts fades.
A key issue therefore is the degree to which domestic policy measures can support activity. As regards monetary policy, the slowdown has prompted the European Central Bank (ECB) to turn more dovish. At its March meeting, the ECB sharply downgraded its forecast for 2019 GDP growth to 1.1% from 1.7%, and said it would now keep interest rates on hold through the end of 2019 instead of just through the summer. In addition, the ECB announced a new wave of cheap funding for commercial banks designed to encourage lending.
However, there are limits to what more the ECB can do to stimulate growth. The ECB’s main refinancing rate is zero, and its deposit facility rate is -0.4%. Low/negative rates have already hit the profits of commercial banks and further cuts could be counterproductive. Restarting quantitative easing (QE), the last phase of which only came to an end in December, could also face technical challenges, given limits on how much debt the ECB is allowed to own.
In turn, the failure to convincingly boost inflation leaves the region vulnerable to deflation risks. The ECB’s current forecasts see inflation at just 1.2% in 2019 and 1.5% in 2020 i.e. a considerable undershoot of the ECB’s ‘below but close to 2%’ inflation target. However, the ECB still sees downside risks to the economic outlook, suggesting inflation could be even lower - a factor that would limit the authorities’ capacity to reduce real, or inflation-adjusted, interest rates.
Could government spending and/or tax cuts come to the rescue? Fiscal policy will turn slightly more accommodative this year, with the structural budget deficit for countries in the region rising 0.3 percentage points to 1.0% of GDP. However, the 2012 fiscal compact – which requires member states to keep deficits within set limits and reduce government debt to no more than 60% of GDP – imposes a constraint on how much fiscal policy can support the economy. Those countries whose public finances would allow for greater easing – notably Germany, which ran a budget surplus of 1.7% of GDP in 2018 – are often reluctant to run large deficits for cultural/historic reasons (the German word for debt – ‘schuld’ – also means ‘guilt’).
In light of these considerations, the eurozone economy seems set to continue its lacklustre performance.
Implications for markets
What does all of this mean for the eurozone’s financial markets? As regards fixed income, the prospect of weak growth, below-target inflation and ‘lower for longer’ interest rates are likely to keep core government bond yields extremely low (the 10-year German government bond currently yields around 0.1%). Against this backdrop, shares in the region’s banks will continue to face headwinds (although recent merger talk has recently lifted the sector). With the weakness of the eurozone economy weighing on the single currency, a more competitive euro could help lift the earnings of overseas earners. On balance, eurozone equities still have a place in a diversified portfolio. But an upgraded assessment is dependent on favourable developments regarding Brexit and ongoing trade disputes, along with more convincing evidence of a pick-up in both the domestic and global economy.
This article is for generic information only and is not suggesting a suitable investment strategy for you. You should seek independent financial advice that takes your individual circumstances into account prior to proceeding with any course of action
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