Eurozone 2019 outlook

Clouds of uncertainty gather – can the European Central Bank keep its “monetary umbrella” open?

Key points

  • Following a disappointing 2018, we expect Eurozone economic growth to drop further in 2019 and 2020, respectively to 1.4% and 1.2%, mainly as a result of the weaker external backdrop
  • Headline inflation should hover around current levels in H1 2019 before moderating on energy base effect. Meanwhile we expect core inflation to gradually and modestly pick up, to 1.2% in 2019 and 1.5% in 2020
  • This should prove enough for the ECB to bring the deposit rate to 0% by spring 2020 – arguing that the negative effects of negative interest rate policy are progressively offsetting its benefits. Although we remain sceptical about an “operation twist”, we expect T-LTRO in H1 2019
  • A heavy political agenda lies ahead, with the European Parliamentary elections in May likely to show further gains for populist parties, and a round of musical chair at top EU posts

A disappointing 2018…

Eurozone economic activity has been disappointing for most of 2018 as some temporary factors distorted growth. These included bad weather conditions and high levels of sick leave in Germany in the context of seasonal flu (Q1 18), strikes in France and accelerating inflation (Q2 18) and disruption in the German car sector due to the introduction of the new EU emission certification system (Q3 18). But more importantly, the moderation in 2018 euro area growth to 1.9% has been driven by a less supportive global environment. After a remarkable boost to growth in 2017 of +0.8ppp (Exhibit 1), net trade moderated in 2018, as the pass-through of past euro appreciation, decelerating global trade and rising trade tensions dampened exports growth. Meanwhile, domestic demand proved resilient, helped by a dynamic labour market and very easy credit conditions.

Exhibit 1: Domestic demand still the main growth engine

Source: Datastream and AXA IM R&IS calculations

… And a further slowdown beckons

Looking ahead, several factors should push euro area growth further down from its 2017 peak of 2.5%, to 1.4% in 2019 and 1.2% in 2020. First, although private consumption will remain the main growth driver, it should slightly decelerate in the coming years on the back of lower job creation. Both consumer and business surveys are indeed pointing to lower hiring intentions and a large, close-to-historical high proportion of firms is actually mentioning labour as a factor limiting production (Exhibit 2). This should lead to slightly less buoyant consumer spending, despite solid wage growth, still easy credit conditions and some fiscal boost (especially in Germany).

Exhibit 2: Job creation slowing

Source: Datastream and AXA IM R&IS calculations

Second, investment should moderate in the wake of high uncertainty and the lack of global traction. We see investment slowing down to 2.4% in 2019 and 2.1% in 2020, from 3.1% in 2018. Most of the deceleration should be driven by corporate investment, while construction should hold steadier, as suggested by historically high confidence indicators, the expected continued strength in housing prices and favourable credit conditions. Conversely, several factors should weigh on business investment in the coming years. Elevated uncertainty, which has already severely affected euro area business confidence, is an obvious one. We believe it has already started to impact firms’ credit demand, which stands at its lowest since Q1 2014, according to the ECB Q3 Bank Lending Survey (Exhibit 3). The weaker external environment, embodied in our forecasts of lower growth in the US and China, is another factor. In the context of a less favourable demand outlook, rising input costs with healthy wage growth but no significant gain in productivity mean that corporate profitability is likely to decline –  again, not a great incentive for investment spending. Altogether we expect investment contribution to growth to drop from an average of 0.8pp of GDP in the 2015-2017 period, to 0.5pp on average in 2019-2020.

Exhibit 3: Elevated uncertainty weighing on credit demand

Source: Datastream and AXA IM R&IS calculations

Last but not least, we expect net trade contribution to growth to turn negative in the next two years, as we foresee a significant deceleration in key trade partners. In addition to the direct trade impact of lower external demand, elevated uncertainty amid recurrent tariffs threats may also take a toll on exports. Furthermore, despite the EUR/USD depreciation in the past few months, the euro’s REER (the trade-weighted measure adjusted for export prices) has only stabilised after rising substantially in late 2017, which is not helping competitiveness. Meanwhile imports should slow but still remain robust, in line with firm domestic demand, leading to an overall negative trade contribution.

Embodied in our forecast, are expansionary fiscal policies - a tailwind worth highlighting. After a neutral stance in 2018, fiscal policies should boost euro area growth to the tune of 0.3pp of GDP. The main support will come from Germany, with the 2019 Budget planning a fiscal easing of approximately 0.75% of GDP (higher spending on pensions, tax relief for low and middle-income earners and 0.5pp of income cut in unemployment insurance contributions). Of course, Italy plans a very loose fiscal stance for 2019-20, but our estimates see tighter financing conditions offsetting most of the fiscal stimulus effect on economic activity. Altogether, Italy should remain the laggard and we expect growth to ease down to 0.6% in 2019, while Spain will lead the pack, despite growth normalising to 2.2% in 2019. Germany and France should move in sync with 2019’s growth pattern falling down to 1.4%, but as a result of different drivers (Exhibit 4).

Exhibit 4: Cross-country differences (contrib. to GDP)

Source: Datastream and AXA IM R&IS calculations

Risks skewed to the downside

Our baseline scenario assumes that no tariffs will be imposed on the EU’s car sector. In addition, we assume Brexit ratification by March 2019, with status-quo maintained at least until the end of the transition phase by end-2020. However should these assumptions prove wrong, trade disruption would severely undermine growth, while related uncertainties would have a negative effect on aggregate demand.

But Italy casts the darkest cloud to our outlook, given the potential risk for financial contagion. In our baseline case, we see Italian growth almost halving next year, its public debt ratio on a slightly rising trend and its deficit hovering around the 3% threshold. The government has recently softened its tone suggesting it could postpone the implementation of some measures, so we acknowledge that we might see some better deficit number, around 2.5% of GDP for 2019. Yet, we believe it will not be enough to avoid the opening of an Excessive Deficit Procedure (EDP), which would rather require a structural reform agenda. Snap elections could lead to significantly less expansionary fiscal policies but are not in sight, as the latest polls are quite inconclusive with Lega and Five Star neck-on-neck. But political dynamics could move, as the economy decelerates further. We think credit rating agencies will closely watch the evolution of financial conditions and their negative effects on growth. In our baseline, we account for spillovers into the economic sector (via the trade impact) but not for financial contagion. Financial spillovers to other peripheries, with a revival of the sovereign-bank loop could damage growth via tighter financial conditions – higher interest rates and reduced credit supply – as well as via a confidence shock. In such a situation, the ECB would likely be forced to deviate from its gradual normalisation of monetary policy.

Inflation: Slowly waking up Phillips

Headline inflation has been on a rising trend in 2018, hitting the ECB’s target of 2% several times since the summer, as a result of higher energy prices. We expect positive energy base effect to support headline inflation in Q1 2019, before fading in H2. On average, we project inflation to reach 1.8% in 2018 and 1.5% in 2019, with a deceleration in 2020 to 1.4%, also reflecting the moderation in economic activity.

Meanwhile, core inflation has hovered around 1.0% on an annual basis through most of 2018, despite the Eurozone’s unemployment rate falling to 8.1% – its lowest level since late 2008. The still elevated labour market slack, reflected in broader metrics such as the underemployment rate which stood at 16% in Q2 2018 (still 2pp higher than 10 years ago) should continue to weigh on core inflation in the near term. We expect that wage growth should nevertheless remain solid, in line with labour market developments and in particular the fact that the job vacancy rate was at its highest in Q2 2018, since 2004. As unit labour costs keep rising, firms profit margin should be squeezed further (unit profit growth slowed to 0.7% on a quarterly basis in Q2 2018 from 2.7% in Q3 2017), leading to some price pressures. We therefore expect the Phillips curve to slowly wake up in H2 2019, pushing the core inflation average to 1.2% in 2019 and 1.5% in 2020.

The ECB won’t remove the umbrella

Although we see the economy slowing and core inflation still substantially away from the ECB’s target, we believe the ECB will go for a 15bps deposit rate normalisation (likely not calling this move “a hike”) in September 2019. And bar a negative surprise, the ECB could then end its negative interest rate policy and lift the refinancing rate to 0.25% in March 2020. The ECB may argue that growth is still above potential, at circa 1.2%, and that such changes are modest and legitimate as the negative effects of negative interest rate policy would be starting to offset the positive ones. In addition to the interest rate trajectory, we think the policy package the ECB will deliver in 2019 might contain some interesting technical details, showing that its “monetary umbrella” remains very much in place. As recently noted by the ECB’s Chief Economist, Peter Praet[1], the Governing Council might decide to operate along two key dimensions, namely liquidity dynamics and duration extraction.

On liquidity, the existing T-LTRO programme amounts to €740bn and is a key policy tool both in terms of its regulation-driven liquidity needs as well as the heterogeneous distribution of this term liquidity. Announcing an extension or a new programme altogether in H1 2019 might be needed, to avoid a large jump in financing costs for the banking sector –  keeping in mind the rate applied to T-LTROs is between main refinancing operations and the deposit rate. Indeed, €399bn of T-LTRO will drop below a residual maturity of one year at the end of June 2019, thus becoming ineligible for Net Stable Funding under Basel III. Furthermore, we note that the regional distribution of T-LTRO-liquidity deviates significantly from the ECB’s capital keys, and hence from the philosophy underlying the public sector purchase programme. For example, Italian banks fetched 33% of T-LTRO liquidity, while at the same time holding a disproportionate amount of domestic government bonds (EUR 379bn). A new T-LTRO would thus alleviate funding difficulties for Italian banks.

We are a bit more sceptical on duration extraction. As QE ends, reinvestment of the principal payments of securities purchased under the asset purchase programme (APP) – estimated at €221bn between October 2018 and October 2019 – becomes a critical policy tool. But skewing the reinvestment toward longer bond maturities via an “operation twist” would face technical constraints, in particular given the high ownership share of the ECB’s holding in some countries (Germany, the Netherlands and Portugal) and the 33% issue/issuer limit. It would also infringe the market neutrality principle. Still, we would like to stress that the latter has been tolerating some flexibility, with the average maturity of ECB APP holdings having deviated quite persistently from the average maturity of outstanding bonds in the market.

Back to a heavy political agenda

The timeline for the replacement of key EU-officials is very intense. The European Parliament elections take centre stage in May 2019, with the right-wing European People’s Party (EPP)’s Manfred Weber a potential (German) candidate for heading the European Commission. However, current polls indicate an increasingly fragmented Parliament, with the balance of relative power drifting away from the traditional centrist parties (EPP and the Socialists & Democrats) to the benefit of Eurosceptic and anti-establishment parties. Decision-making is likely to be subject to complex alliances and time-varying cross interest, most likely ending up in policy inertia. Turning to the ECB, half of the Executive Committee will rotate, starting with Peter Praet by end-May. In addition to President Mario Draghi (31/10/2019), Executive Board member Benoît Cœuré’s term will expire at the end of December. These are two very “hot seats”, but we do not think that any outcome will significantly change the ECB’s reaction function. Unsurprisingly, the timing of the European Parliament elections complicates matters, as key stakeholders are trying to best position their representatives and therefore have to commit to political trade-offs. In any case, the “new” ECB will be confronted with a rather challenging macroeconomic environment. As such, a continuation of the current constructive dialogue with market participants will be essential for the successful conduct of monetary policy.

 

Table of contents:

Executive summary 

  Eurozone outlook
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  US outlook
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  China outlook
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  Japan outlook
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  UK outlook
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  Emerging markets
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  Investment strategy
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[1] Praet (November 2018), Preserving Monetary Accommodation in Times of Normalisation, speech.

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