A few cylinders misfiring
12 June 2018
At the start of this year, we described the Eurozone economy as “firing on all cylinders”. Almost six months into the year, it looks like a few cylinders have started to misfire. The first quarter GDP print came in at 0.4% quarter-on-quarter, down from a consistent 0.7% throughout the previous year. Domestic demand remained robust, with consumption and investment both posting solid increases. But net trade was a drag on overall GDP growth (see Chart 6), with both imports and exports declining – albeit the latter by more. Meanwhile, survey data relating to the second quarter have continued to come in soft, with both confidence indices and the PMIs losing further momentum. Temporary drags have played a role, but the Eurozone also faces some more fundamental headwinds that were less pressing at the start of the year, including the lagged impact of earlier euro appreciation, higher oil prices and rising capacity constraints in some member states. Overall, we’ve lowered our 2018 GDP forecast from 2.3% at the start of the year to 2.1% now. This reflects both the disappointment at the start of the year, but also some slight drags from these headwinds.
Meanwhile, the Italian general election loomed large on an otherwise light European electoral calendar at the start of the year. Fast forward to last month and the approval of the 5 Star Movement – League government, and investors’ worst nightmares appeared to be coming true. The longevity of the Italian government is highly uncertain, but that may increase the parties’ desire to pursue populist policies ahead of possible fresh elections. The government is planning to incorporate both parties’ pet economic policies by introducing universal basic income and cutting taxes, while rolling back pension reforms. If enacted fully, these are likely to cause the budget deficit to balloon, from 2.3% of GDP now to as high as 8%. The EU’s response to fiscal slippage and immigration policy changes will be key for markets, as a hard-line approach risks sparking more Europhobic tendencies in Italy.
On the inflation front, at the start of 2018 we were revising up our Eurozone inflation forecasts on the back of higher commodity prices. Those upward revisions have continued over the first half of the year, as the euro-denominated oil price has risen 10% since January (and at one point the rise was more than 20%). Headline HICP inflation hit a 14-month high of 1.9% in May, and is likely to breach 2.0% over the next few months as higher oil prices are passed through to consumers. We now see inflation averaging 1.7% over the course of this year as a whole, up from a forecast of 1.4% at the start of the year. But we haven’t observed the same strong upward pressure on core inflation measures (see Chart 7), which we expect to rise only very gradually as spare capacity continues to be eroded. The upshot is that ECB policy appears to be proceeding broadly as we had expected: we continue to anticipate a tapering down of net asset purchases over the course of Q4, which looks likely to be announced either this week or at the July meeting. And we see a first rate rise, hiking the deposit rate by 20 basis points, in September 2019.