A Stronger Eurozone Economy, Despite Higher Volatility On Bond Markets

European government bond yields have risen markedly since the beginning of fall 2016. But “this time, it’s different,” or at least it should be. Indeed, the landscape of the eurozone economy has dramatically changed since the 2010-2012 sovereign debt crisis.

German sovereign bond yields rose 25 basis points (bps) between mid-October and mid-February. The rise has been sharper for French and Italian yields (+80 bps) than for Spain (+50 bps) and the Netherlands (+40 bps). Portugal has experienced the most acute upward pressures on long-term interest rates (+115 bps), back to levels seen in March 2014.
Several factors are behind the upward movement. One is the pickup in inflation, primarily owing to recovery of oil prices and the prospects for expansionary U.S. fiscal policy under Donald Trump’s presidency, which led financial markets to question assumptions of a sustained period of low inflation globally. More recently, concerns about election risk in several European countries have pushed up sovereign spreads over German Bunds.
French presidential elections are in the spotlight and the country’s government bond yields increased to a four-year high. Investors are concerned about a perceived higher likelihood of a victory of the National Front’s Marine Le Pen. Italy in the meantime is entangled in a political deadlock, meaning that 2017 could be a lost year in terms of much needed reforms. The Italian economy seems to struggle with structurally weak growth and inflation, leaving the populist Five Star movement to allege that leaving the euro would solve Italy’s economic problems.

A Very Different Economic Backdrop From 2010-2012
On the other hand, economic conditions in the region have improved substantially. Last year was the first time since 2008 that real GDP growth in the euro area surpassed that of the U.S, albeit marginally. The economy expanded by 1.7% in 2016 compared with 1.6% in the U.S. The recovery was broad-based among countries and primarily domestically driven.
In Germany, GDP accelerated to 1.9% last year from 1.5% in 2015. Economic growth came primarily from domestic demand. The management of the high number of refugee arrivals has been reflected in a mild expansionary fiscal stance in the country. Annual public spending is likely to have risen by more than 4% last year, the highest growth since 1992 and the reunification years. Meanwhile, the rising demand for property owing to high immigration and low mortgage interest rates has led to a continued revival in the construction sector.
In France, economic activity accelerated to 0.4% quarter on quarter in last quarter of 2016, and expanded by 1.1% for the year as a whole. Consumer and investment spending contributed the most to GDP growth. In Italy, growth was slightly disappointing. GDP growth decelerated by 10 bps to 0.2% quarter on quarter and economic growth reached only 0.9% for the whole of 2016. Both consumer spending and investment remained feeble. More structurally, Italy’s vulnerabilities lie also in an uncertain political outlook, which will probably remain in focus this year. In Spain, the economy grew by 0.7% quarter on quarter in the fourth quarter of 2106 and by 3.2% over the full year. The growth was primarily driven by domestic demand. In particular, a dynamic labor market, the rebound in consumer expectations, and stronger credit to households underpinned consumer spending.
We believe that the positive momentum in the euro area has continued to build at the start of 2017, especially in the manufacturing sector. While it is too early to draw strong conclusions about the likely pace of growth in the first quarter, business surveys, particularly from the manufacturing sector, paint a positive picture for near-term outlook. On the domestic front, the key issue is how resilient the recovery in the region will be in face of higher inflation. While private consumption is likely to be under pressure from higher inflation, we think that a sustained recovery in employment will help offset this. January’s flash inflation release revealed that consumer price index inflation climbed to 1.8% from 1.1% in December, mainly owing to a surge in energy inflation.
We forecast GDP growth will average 1.4% this year compared with 1.7% in 2016. Still favorable financial conditions will continue to benefit the corporate sector, but investment is facing headwinds from political uncertainty, with general elections taking place in France, the Netherlands, and Germany, and from the negative impact on trade from the Brexit vote.

Monetary And Financial Conditions Are Also More Favorable Than In 2010-2012
Monetary conditions remain highly supportive overall. Despite higher headline inflation and encouraging signs of a stronger economic recovery, we continue to expect the monetary policy of the European Central Bank (ECB) to remain accommodative. The central bank is likely to embark on a very gradual and cautious reduction of asset purchases to perhaps €40 billion a month in the second half of 2017, with an additional cut in the first half of 2018. Sustained demand for sovereign bonds from the ECB is likely to maintain some downward influence on yields in the eurozone. Moreover, we think interest rate hikes by the ECB still seem unlikely to take place before 2019 and a sustained adjustment in core inflation.
In addition, public finance balance sheets are in a healthier position. Major economies in the euro area such as France, Italy, Spain, and Belgium have seen their debt ratio stabilize since 2014. Germany and the Netherlands have achieved a low debt ratio and might even have some fiscal room. What’s more, the record low interest rates experienced between 2013 and 2016 provided governments with the opportunity to lock in low long-term borrowing costs. According to Oxford Economics, the average effective interest rate paid by the Italian and Spanish governments fell from 4.8% and 4.4%, respectively, in 2008, to just below 3% in 2016. The recent rise in government bond yields should be seen more as the beginning of the end of a windfall period for governments.

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