Europe Economy 2Q19: Tilting toward weakness
The EC joined the IMF and OECD in dialling down growth expectations for the Eurozone and EU. Growth has retreated for five successive quarters, from a peak of 2.8% y/y in 3Q17 to 1.2% in 4Q18. Apart from cyclical forces, seeds of the current slowdown were largely domestic catalysts i.e. stricter regulations on the auto industry and simmering political challenges.
Concurrently, global trade entered a correction phase, compounded by uncertainty regarding trade policies, particularly US-China tariff-exchanges, slowing global manufacturing activity, and loss of momentum in China/US/Asia growth. The overhang of Brexit-driven uncertainty has been an additional headwind.
High-frequency data mirror this cautious view. Survey indicators, including PMIs, have been slowing for several months, with real data playing catch-up since 2H18. With the US stepping up tariff action with its key trading partners, including China and the EU, manufacturing and trade activity have weakened since late-2018, led by a downturn in the core economies.
Even as we expect consumption (helped by low sub-8% unemployment rates and better wage growth) and investments to pick up part of the slack, the underlying loss in momentum has tilted the bias for weakness, as spillover effects are likely. We lower our 2019 growth forecast to 1.2% y/y and 2020 to 1.5% (vs 1.8% previously).
Inflation risks have subsided with a moderation in global energy prices. Headline inflation is expected to ease to 1.3-1.4% y/y in 1Q19 vs ECB’s target of 2%, and a peak of 2.1% in 3Q18. Core inflation has flatlined, while markets-based inflation expectations drift down.
We dial down our forecasts to 1.2% for 2019 vs 2018’s 1.7%, and 1.3% for 2020 (vs 1.4% previously).
The ECB withdrew from QE purchases since this year but assured that the practice of rolling over existing bonds it holds will continue. Apart from putting rate hikes on hold for the rest of the year, a fresh tranche of two-year TLTROs has been announced, which will help preserve favourable lending conditions and jumpstart policy transmission.
ECB President Mario Draghi will step down this year, with markets likely to monitor remarks of key contenders for the post, with the Banque de France head Francois Villeroy de Galhau and Governor of the Dutch central bank Klass Knot, reportedly in the running. Both officials have called on the ECB to maintain an accommodative policy considering the deteriorating growth outlook.
A tougher economic backdrop is likely to bring political differences to the core. Alongside Germany that is facing problems of its own, Italy has reached a fragile truce with the EC over its fiscal targets, just as French President Emmanuel Macron faces mounting pressure to renege on key reforms in recent months in the face of strong protests. Spain remains stuck in a cycle of political instability, but a disorderly Brexit is the elephant in the room for Europe.
Rate differentials between the US and Eurozone (also reflected in balance-sheet direction in the accompanying chart), will weigh on EUR/USD. Beyond safe-haven flows, a dovish ECB might be a signal for investors to add risk and yield, and see interest return to the likes of Italian bonds.
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