Threats to the European Cyclical Recovery

The eurozone is in the midst of a cyclical rebound thanks to lower interest rates, the weaker euro, reduced fiscal “drag” in some countries, lower oil prices and other factors, but threats abound

Heatmap: Roubini’s End-2016 GDP Growth Forecasts for Europe (%)

Source: Roubini Global Economics

Greece Rudely Interrupts
Until the Greece debt negotiations went into crisis territory, the eurozone was in the midst of a weak cyclical rebound that began two years ago, supported by domestic consumption, less self-immolating austerity and, to a lesser extent, net exports, as the region (especially core countries like Germany) gained from the weakness of the euro.
Even with the immediate threat of “Grexit” averted, downside risks remain and a broader structural recovery remains elusive.
For the latter, the authorities would have to do much more to support aggregate demand.
As such, we expect the ECB will continue quantitative easing beyond 2016 and see the euro continuing its downward trajectory against the U.S. dollar at a moderate pace. We see two main scenarios ahead for Greece, which have differing effects on the rest of Europe.

Scenario 1: Spillovers Contained
In this scenario (the base case and where we seem to be at present), the impact of bank closures and capital controls would be contained and any spillover effects would be marginal on other periphery countries. Indeed, Germany and France, might perform slightly better because of the easing of financial conditions as a direct consequence of the lower yields boosting private-sector investment. In Spain and Italy, a weaker euro would offset slightly higher yields, limiting the impact on GDP.
The repercussions of austerity and mild bank/capital controls for Greece are negative and self-defeating, but, for the eurozone in aggregate, the impact would be contained, with no great difference in annual growth rates—it would continue on its cyclical rebound and moderation in 2016.

Scenario 2: Greece Defaults (but no Grexit)
This scenario of “limbo” for Greece is a longer extended version of Scenario 1, with all shocks lasting two quarters. However, here, Greece would also default on some of its debt and, as a result, there would be movements in yields for countries that are susceptible to either safe-haven or contagion flows. This scenario is most likely when Greek Bailout 3.0 falls apart.
In that case we would see larger and more significant spillover effects into the wider eurozone. The two countries outside Greece that would be significantly affected under this scenario, especially in 2016, are Italy and Spain, which would lose -0.5 pp and -0.3 pp of growth compared with our baseline view of those countries. Italy would be affected through a combination of a worsening trade balance and a decline in investment; Spain mostly through investment. The latter would be influenced by a rise in the real cost of capital as rates increase.
In Germany, the impact of a downturn in intra-eurozone trade would also be large, with a negative contribution to growth in 2016. However, the lower cost of capital would increase private-sector investment, leading to a net gain in 2016. France would be a similar story.
As a whole, the impact of this scenario would reduce eurozone growth from our baseline forecasts by as much as 0.1 pp and 0.4 pp in 2015 and 2016, respectively, assuming firewalls prevent spillovers from taking hold. But the rest of Europe would stand to benefit by somewhere in the realm of 0.2-0.3 pp in terms of 2016 growth, as a result of the positive spillovers from the flight-to-safety impact on yields.

What to Watch

1. Greek negotiations and reform plans: Can the government keep the reform show on the road enough to get ESM funding? Slippage could quickly lead to Grexit.
2. Spain’s election(s): A Podemos surge would lead to market jitters and weigh on growth via reduced investment.

ETF Securities Research and Roubini Global Economics