HSBC’s outlook for the European economies divides into the short term, where a modest recovery is expected to continue, and the longer term, where the challenges are becoming ever more stark.
In the short term, the impact of the UK’s Brexit vote has not been as severe as initially feared; the continued ECB quantitative easing programme and more support from the BoE are giving indebted European governments a huge amount of fiscal support and growth is decent if not spectacular at around 1.5% in the eurozone. Europe, in other words, is muddling through.
But even peering beyond the end of this year, the challenges start to become more apparent.
There are uncertainties over the QE programme, and whether and how it is extended. The real hard work on negotiations over Brexit will begin. And the depth of the mood of discontent – shown by the Brexit vote and reflected in the rise of populist parties across Europe – will become clearer in the outcome of elections in France, Germany and the Netherlands.
And then there is the longer term. We are strongly of the view that the lacklustre nature of the recovery is sowing the seeds of longer term problems. Investment in physical and human capital is very low. The eurozone seems to be settling into a low-inflation rut. Demographics are far from favourable with working age populations quite likely to shrink in Germany, Spain and Italy within the next few years. And Brexit could yet cause long-term damage to both the European and UK economies.
Let’s take the short term first. Neither the UK, nor the broader European, data have slumped following the UK’s decision to leave the EU. Indeed, UK growth in the third quarter could be stronger than we previously anticipated, leading us to lift our full-year forecast to 1.8% from 1.5%. However, UK investment is likely to be the first casualty of the Brexit vote and with more than half of the UK’s capital goods imports coming from Europe, this could partly explain the gradual slowdown in the industrial indicators we have seen over the quarter. And UK GDP could suffer if consumer spending ends up being affected by the impact of sterling’s depreciation on headline inflation. We are keeping our 2017 forecast for UK growth at 0.7%.
We also haven’t changed our forecast for growth in the eurozone in 2017 − it remains at 1%.
Investment growth is likely to remain moderate. Moreover, consumption growth has already slowed and is likely to stay lacklustre given the tailwind from low oil prices is well and truly behind us. Net exports saved the day in Q2, preventing a more significant slowdown, but the manufacturing surveys suggest exports are weakening into Q3. The slowdown would be more pronounced if it weren’t for expansionary fiscal policy.
The political backdrop is hardly conducive to corporate confidence. It is not just the uncertainties around Brexit. Over the next 12 months Europe faces an Italian constitutional referendum, a possible third general election in Spain, presidential and parliamentary elections in France, and general elections in the Netherlands and Germany.
Spain could be heading back to the polls for a third time since last December as the leading political parties have so far once again failed to find sufficient common ground to form a coalition. In Italy, the diminishing popularity of prime minister Matteo Renzi has led him to push back the date for his critical referendum but it is still expected before the end of the year.
Whether he can distance himself from his earlier promise to resign in the event of a ‘no’ vote remains to be seen. In France, it is not yet clear whether the current president François Hollande will stand for re-election next year; even if he does, labour market malaise could dent his prospects, and polls suggest it is increasingly likely a Republican party headed by either Nicolas Sarkozy or Alain Juppé might go head to head with Marine Le Pen. In the Netherlands Geert Wilders of the Dutch Freedom Party still has high hopes of winning the Dutch election in March. In Germany, where there is an autumn election, we will discover how far the rise of the anti-immigration party Alternative fu?r Deutschland has gone – Angela Merkel, who has been in power for 11 years, has yet to declare whether she will be standing.
The markets are so far calm in the face of all this political risk. We are constantly surprised by how powerful the QE sedative is, particularly on sovereign markets. Perhaps it’s because of this calm that the Bratislava summit on 16 September failed to deliver anything particularly noteworthy. Despite Donald Tusk, president of the European Council, promising the day after Brexit to use this meeting for “a wider reflection on the future of our Union”, security concerns and the refugee crisis were the main talking points. Lip service was paid to broader economic issues and the future of the Union but there was very little concrete action.
… but with longer-term consequences
Many of these distractions and short-term issues are storing up problems for the longer term. Hence we are reluctant to factor in any kind of ‘normalisation’ as we provide our forecasts for 2018 for the first time.
First, investment in physical or human capital is very low and productivity continues to disappoint. Economists worry about lasting damage from recessions – so-called ‘hysteresis’ effects. This is where a lack of demand eventually leads to permanent damage to supply as resources lie idle for too long. Unfortunately the evidence is mounting. Moreover, given recent events, security concerns and the refugee crisis are at the forefront of voters’ minds. Spending in these areas will take precedent. The likelihood of governments focusing spending on policies to boost medium-term productivity is diminishing ever further.
Second, the problem is likely to be a nominal as much as a real one. We think it is becoming increasingly clear that the eurozone is settling into a low-inflation rut. The stability of most of the main sub-components, at levels much lower than in the past, is cause for concern. Moreover wage growth − a major intermediate target in the fight to bring inflation back to target – seems to be rolling over. As Japan shows, once inflation expectations get stuck at a low level it is very hard to convince households and corporates to aim for something higher.
We expect nominal GDP growth in the eurozone to be just 2% in 2018. This is well below what official forecasters are predicting. Amongst other things, growth as low as this will make it difficult to repair government cash shortfalls. Mario Draghi, the ECB president, may have shown some reluctance to extend QE in September. But pressure on government finances isn’t going away…and neither therefore is QE. We continue to advocate the need to extend QE by a further six months to September 2017.
Karen Ward – Chief European Economist – HSBC Bank plc