A series of unfortunate events
The survey of forecasters by Consensus Economics expects 2019 European GDP growth of 1.3%. This is above-trend growth of around 1% but is a significant downgrade from a year ago when the consensus was predicting 1.8% growth in 2019. Europe has suffered from several one-off events that have depressed growth. These include the shift to a new emissions testing regime that caused a collapse in German automobile production, the political turmoil in Italy, Brexit uncertainty, the U.S./China trade dispute and the populist yellow vest/gilets jaunes protests in France.
It’s not clear yet whether these factors are temporary, meaning Europe should rebound during 2019, or whether there is a deeper underlying cause of weakness.
We’re in the ‘mostly one-offs’ camp and expect to see eurozone growth improve through the year. German motor vehicle production is already rebounding, a China trade deal is looking likely, a hard Brexit is becoming less likely and Italy looks less risky. Regarding the latter, Italian 10-year bond yields are nearly 120 basis points (bps) below their October 2018 peak as of mid-March.
Fiscal easing is likely to provide a decent tailwind, with the European Commission expecting that eurozone fiscal thrust will be 0.4% of GDP this year. The European Central Bank (ECB) has become more dovish, pushing out its guidance on the timing of the first rate rise to the end of 2019 (however, we don’t think a rate hike is likely until mid-2020 at the earliest) and outlining a new program of cheap bank funding to replace the TLTROs (targeted long-term refinancing operations) that mature next year. Furthermore, European households are in relatively good shape with falling unemployment and rising wages.
- Business cycle: The cycle should improve over the coming months as the impact of one-off events starts to subside. Exports to emerging markets are equal to nearly 10% of eurozone GDP, so the region will be a beneficiary of a thaw in the trade war.
- Valuation: Eurozone equity valuations are neutral while core government bonds are long-term expensive.
- Sentiment: Contrarian sentiment signals were heavily oversold in late December, but they have moved toward neutral with the subsequent equity market rebound. Equity price momentum is flat.
Europe has a track record of disappointing, so it’s worth thinking about the main risks.
- Italy moves back into crisis: GDP data confirm Italy was in recession during the second half of 2018, and GDP growth will probably be negative during Q1 of 2019. The political situation is volatile, and we can’t rule out new elections in 2019. The likely winner would be a Matteo Salvini-led center-right coalition controlled by the Lega political party. This could provide more political stability, but it could also trigger more clashes with the European Commission over fiscal policy.
- ECB makes a policy mistake and tightens too early: This risk has declined following the dovish turn at the March ECB Governing Council meeting. The key issue now is the leadership of the ECB when Mario Draghi’s term as president expires at the end of October. The moderately dovish Finn (and former governor of the Finnish Central Bank) Erkki Liikanen appears the favorite to replace him, but the appointment of Jens Weidman, Head of Germany’s Bundesbank, would signal a hawkish shift.
- Credit growth remains lackluster: The weakness in credit flows over the past few months is a concern (see the chart below), both from the aspect of earnings-per-share (EPS) growth in the largest equity sector, financials, and the near-term outlook for economic activity. Continued weak credit growth will indicate deeper eurozone malaise. We will be tracking monthly credit flows closely.
- Trump imposes tariffs on European motor vehicles: President Trump has had a report on his desk since Feb. 17 from the U.S. Commerce Department that probably recommends a 25% motor vehicle tariff. He has 90 days (until May 18) to announce a decision, and we believe a decision to implement tariffs seems unlikely.
- Hard Brexit: This would affect exports, supply chains and confidence. It’s looking less likely, but the UK political situation is very unpredictable.