Market Confidence In The Eurozone’s Recovery Is Under Threat

Real GDP grew by 0.3% in the final quarter of 2015 and by 1.5% for the year as a whole in the eurozone. As in 2014, domestic demand was probably the main driver. The expenditure components of GDP have not been published yet for the region as a whole

The eurozone economy has been recovering since second-quarter 2013, but so far the turnaround has been uneven and fragile compared to historical standards–mainly because of muted investment growth. Painting an overly favorable picture of GDP in the second half of 2015, business surveys, including the composite purchasing managers’ indices (PMI) and the European Commission’s Economic Sentiment Indicator, pointed to growth of 0.5% in the third and fourth quarters. In contrast, actual growth averaged 0.3% in both quarters. In January, both indicators edged down, but remained at levels still indicating expansionary territory. The final eurozone PMI reading was 53.6 for January, below the 54.3 reading in December, marking the lowest reading in five months. This suggests that at the start of the year, the economy is struggling to maintain its current quarterly growth of 0.3%.

The Juncker plan for investment hasn’t lived up to its promise yet
Prior to the very recent financial market turmoil, we had expected only moderate investment growth of 2.6% in the eurozone this year because of weak global external demand, subdued domestic demand prospects, and the need to deleverage in the nonfinancial private sector. Indeed, household and nonfinancial corporations still bear a heavy burden of debts that they took on in boom times and still represented close to 205% of GDP in third-quarter 2015. In
comparison, the U.S. took bad debts off bank balance sheets early after the 2008-2009 financial crisis hit, allowing credit to rebound more strongly. In contrast, the large stock of nonperforming loans (NPLs) in Ireland, Italy, Spain, and Portugal represents a handicap to the transmission of monetary policy (see chart 1), although NPLs in Spain and Ireland started to trend down in 2013. As a result, credit growth in the eurozone private sector has remained subdued, growing by a meager 0.9% year on year in December. While France and Germany have seen decent credit growth to households and businesses, ranging between 2% and 3%, Ireland, Spain, and Portugal are still experiencing negative credit growth, of an annual -10.3%, -3.9%, and -3.8% in December. In Italy, lending growth turned positive in September, but remained weak at +1.2% in December.

The Juncker investment plan, designed to promote investment and achieve regulatory harmonization in the transport communication and electricity energy industries, has had a slow start. Investment planned for three years (2015-2017) was approximately 2.25% of 2014 GDP. According to European Commission estimates, less than 0.5% of GDP of investments has actually been approved as of January 2016.

Eurozone growth prospects are vulnerable to a confidence shock
While we continue to expect domestic demand to remain resilient this year, a number of uncertainties are mounting that could threaten consumer and business confidence, eat into credit activity, and delay investment decisions: worsening emerging-market economic prospects, low oil prices, geopolitical tensions, a possible Brexit, and financial market volatility, among others.
A recent OECD simulation tried to assess the effects of a new shock on EU growth. According to the Organization, a drop in corporate investment by 2.5 percentage points in 2016 and 2017 caused by a weakening in confidence would knock off 0.5% from GDP by 2017. Adding a 50 bps spike in equity and investment risk premiums (which is only a sixth of what was experienced at the height of the sovereign crisis in 2011) would result in a loss of GDP of 1.2% over two years, compared to the baseline.

Credit growth in the periphery remains exposed to a spike in bond yields
Growing concerns about the strength of the banking sector in the eurozone, together with a widening in spreads in the periphery sovereign bond market, could weaken the recovery in credit and investment. Over the past few weeks, credit spreads for banks have widened sharply while bank equity prices have fallen to lows not seen since August 2012 (see chart 2). New concerns are adding to existing nervousness about the large stocks of NPLs and regulatory changes to implement the EU’s Bank Resolution and Recovery Directive, which took effect in January 2016. The BRRD aims to protect taxpayers from the costs of future banking system crises and introduce bail-ins for holders of bank equity, and junior and senior debt, as well as large depositors (above €100,000). Further negative policy rates from the European Central Bank (ECB), expected to be announced in March, could weaken net interest margins for banks in the region.

Yield spreads on Italian and Spanish 10-year bonds jumped to 130-150 bps over German Bunds on Feb. 17, up from about 95 bps at the same period last year. More concerning, Portuguese spreads have surged to 320 bps (up from 135 bps) because of political uncertainties (see chart 3). While these levels are low by crisis standards, they are rising even though the ECB is buying the debt of these countries in large volumes under its quantitative easing program. The central bank has been successful so far in closing the spread between corporate lending rates in Italy and Spain and those in Germany, and in reducing it between Portugal and Germany. We think the turmoil in sovereign and bank bond markets in the eurozone could reopen spreads, leading to a more subdued recovery in credit and investment.

Sophie Tahiri – Economist – Standard & Poor’s
Jean-Michel Six – Chief Economist – Standard & Poor’s