Euro area shows the UK how it’s done

With the arrival of summer, Europe’s weather has naturally taken a turn for the better, with warmer and sunnier days providing their usual feel-good factor. Somewhat less routine, the outlook for the euro area economy continues to brighten too, with no shortage of reasons to be cheerful.

Revised data released this month revealed that economic activity in the euro area at the start of the year was stronger than originally thought, with GDP in Q117 up 0.6%Q/Q, the strongest rate in a year and comfortably above the 0.4%Q/Q post-crisis norm. As has typically been the case since the euro area’s economic recovery began four years ago, GDP growth was fully accounted for by domestic demand, with private investment (encouragingly) the principal driver. And growth was seen across the member states. While Spain and Germany led the way with growth of 0.8%Q/Q and 0.6% respectively, the pace of expansion in France and Italy was also above recent trend rates.    

All indications are that GDP growth will be at least as strong everywhere in the second quarter. Certainly, economic surveys are pointing in that direction. The euro area composite PMI was at a six-year high in the first two months of Q2, suggesting an acceleration in growth, while the Commission’s economic sentiment index points to the best quarter since 2007. These surveys are also signalling increasingly broad-based growth, with sentiment across all business sectors close to or at multi-year, and sometimes decade, highs. And with the euro area unemployment rate down in April to a nine-year low of 9.3%, employment rising at its fastest rate of the recovery so far in Q1, and businesses also signalling their intention to increase recruitment at a quicker rate over the near term, consumer confidence in Q2 is set to be the highest for a decade too.   

So, when its Governing Council met last week, the ECB revised up its growth forecasts, expecting it to reach about 2%Y/Y this year, which would be the best rate since 2011, and about 1¾% in each of the next two years – a projection that is very close to our own. And with the balance of risks to the economic outlook now broadly balanced, the ECB’s policy announcement brought a small but substantive amendment, which arguably represented a first tightening of the monetary stance since Trichet’s ill-judged rate hikes in 2011. Specifically, the Governing Council changed its forward guidance, dropping its long-standing suggestion that interest rates might be lowered further before the end of the asset purchase programme.

But, while the outlook for euro area economic growth has improved, the opposite appears to be the case for inflation. Indeed, having fallen to 1.4%Y/Y in May, CPI has probably already passed its peak for 2017, while core inflation slipped back below 1%Y/Y close to the middle of the range of the past couple of years. And given lower energy prices, the recent appreciation of the euro, and the continued subdued nature of underlying price pressures, the ECB revised down its inflation outlook for this year and the next two years. Notably, the 2019 forecasts for both headline and underlying inflation were nudged down to a level still some way below the ECB’s target of below but close to 2%Y/Y. And with those forecasts predicated only upon the completion of its current programme of asset purchases of €60bn per month up to year-end, they suggest that the ECB will extend its asset purchases beyond the end of 2017, albeit at a slower pace at present and probably tapering to zero around mid-year. We expect the Governing Council to take a decision on this in September. 

It’s not only the economic data that provide reason to be upbeat. Political developments have also been promising. While investors had originally approached the year with a sense of foreboding, wary of the risks of a populist backlash that might threaten the very existence of the single currency in any one of this year’s elections, the opposite has been the case. Voters have turned their backs on the demagogues in favour of the centrists and technocrats, a trend that might eventually encourage Germany to relax some of its objections to further integration in the euro area over coming years.

Of course, political events have been most remarkable in France where, following Emmanuel Macron’s win in last month’s Presidential election, his La République En Marche (REM) party is now set to seal a huge parliamentary majority on 18 June. As such, while they are bound to face significant opposition from the unions and others, Macron’s planned economic reforms, particularly to the labour market, should be assured safe parliamentary passage. That could give a welcome boost to France’s potential economic growth rate. And given that prospect, the spread of French government bonds over German Bunds has now narrowed to its lowest level this year.   

Investors have also pushed Italy’s bond spreads to their lowest in almost six months, relieved that the country’s anti-euro Five Star Movement fared poorly in municipal elections this month. So, perhaps the next Italian general election – due by next May – need not be approached with quite so much trepidation as previously feared. Elsewhere, the expulsion from Finland’s government of the more extreme members of the populist True Finns party, including its hot-head leader, should be conducive to greater stability. And, for the time being, investors appear unconcerned about the Catalonian independence referendum slated for 1 October, particularly since that result will not be binding.

So, the economic and political outlook for the euro area is looking increasingly strong and stable. Sadly, the contrast with the UK could not be starker, with Prime Minister Theresa May’s claims to those same qualities having been brutally exposed over recent weeks as her general election campaign turned into a slow-motion car crash. The result – a hung parliament with the Conservative Party clinging to power only by kowtowing to a small party of Northern Irish Unionists – raises profound uncertainty over both her own future and UK economic policy, not least with respect to Brexit. And, after UK GDP slowed in Q1, rising just 0.2%Q/Q, the weakest of all G7 countries, such uncertainty seems likely to weigh heavily on business investment just as declines in real wages take their toll on consumer spending. So, as the ECB ponders its exit strategy from its highly accommodative policy setting, while a few outliers on the MPC this week thought it fit to start tightening policy, we doubt that the BoE would dare to amend policy for several quarters to come. Certainly, while the euro area’s economic future is looking increasingly bright, thanks not least to its politicians’ poor judgement and failed Machiavellian manoeuvres, Britain’s outlook looks increasingly bleak.

Daiwa economic forecasts 

Daiwa Economic Forecasts_17Jun17
*Monthly target €bn, end of period. **Monthly target £bn, end of period. Source: Bloomberg, ECB, BoE and Daiwa Capital Markets Europe Ltd.

*This article was originally written for and published in Japanese by NNA Europe (       


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