Back to the Brink?

Brexit introduces fresh headwinds to growth – headwinds that are reinforced by rising political risks in key EU countries. While inflation should start to rise soon, we still expect additional ECB action and see prospects for some fiscal easing.

Materially lowering our European GDP growth forecasts: In the wake of the UK vote to leave the EU, we are lowering our euro area GDP growth forecasts by a total of 1pp for 2016/17 on the back of higher political uncertainty, tighter financial conditions and lower economic sentiment. We are cutting our 2016 forecast from 1.5%Y to 1.3%Y and our 2017 forecast from 1.8%Y to 1.0%Y. Hence, instead of accelerating into next year, we now see the economy slowing in the coming quarters. The euro area will still be growing at a rate that is close to its long-term potential, preventing unemployment from rising materially. We judge consumer spending to be relatively resilient, but are worried about companies shelving investment projects.

Inflation likely to rise less, ECB expected to do more: A rebound in oil prices and sizeable base effects will likely start pushing headline inflation sharply higher in the remainder of this year. In the second half of next year, we see headline inflation hovering around 1.5%Y. All in all, we are marking to market our 2016 average HICP forecast from 0.2%Y to 0.3%Y, while lowering our 2017 forecast from 1.7%Y to 1.5%Y. On the back of the downwardly revised growth and inflation forecasts, we expect the ECB to take additional policy action. In line with its forward guidance, we expect the bank to cut the deposit rate to -50bp. In addition, we now see the ECB extending its QE programme by six months to September 2017 and adding bank bonds to the buying.

Rising political risks, difficult Brexit negotiations: While protest parties across the continent are being galvanised by Brexit, we deem the exit of other countries from the EU as very unlikely. Key political event risks lie ahead, ranging from the Italian referendum to the elections in France, Germany and the Netherlands. Political discontent seems to be spreading from the periphery to the core and, like in the UK, seems to centre on immigration. In our view, it is deeply rooted in limited opportunities, notably in educational attainment, and income inequality. Political fragmentation will make it more difficult to push through economic reforms and negotiate new trade deals with the UK, the US and Canada, and could complicate deploying fiscal policy measures.

Elga Bartsch, Daniele Antonucci, Carmen Nuzzo, Joao Almeida, Jacob Nell, Melanie Baker CFA – Morgan Stanley & Co. International Plc