Eurozone spring headaches

While spring is well advanced, the weather is so unstable that it is not that clear which season we are in. Could this be a fair introduction for a pure macroeconomic analysis of the Eurozone in early May 2016? Probably yes.

Last year was the first year with decent growth following the Eurozone sovereign crisis. But with the benefit of hindsight, conditions should have been stronger taking into account all the tailwinds potentially pushing the Eurozone economy (low interest rates, depreciating currency, falling oil prices).

This year seems different. It has been characterized by marked volatility in financial markets from the very start, but also by signals of more resilient than expected domestic demand. It remains unclear whether the economy is taking another step towards normalization or is headed for a more troublesome period.

Economic Outlook: Not that Bad
Preliminary GDP in Q1 revealed a strong 0.5% QoQ growth. However, it seems likely that some payback will happen in Q2, related to market turbulence at the start
of the year and the resulting decline in confidence. Indeed, our leading indicator is pointing toward a mild slowdown in the next coming months. Provided political
events will not create too much turbulence (see below) this slowdown should be temporary, and in Q3 a quite strong growth path will be resumed. Note that French
figures (the only country to have provided detailed data at this point) suggest a promising Q1 jump in investments.

Domestic demand will likely be the engine of growth, with consumer spending maintaining a good pace, while Gross Fixed Capital Formation is expected to accelerate markedly. On the other side, net exports will contribute negatively to growth in 2016. Inflation will likely remain low (probably below 0) in H1, mildly rising in H2. According to our expectations, the average in 2016 will be just a tad higher than in 2015 (0.1%-0.2%) but with a rising profile, due to a slight upward trend in oil prices and base effects at play. Inflation should approach (without touching it) the ECB target only toward the end of 2017.

What is Working and What is Not?
The main engine of growth is private consumption, and it is clear that this is coming from some gains in real disposable income that are mainly going toward
consumption. The rise in real disposable income is due to improvements in the labour market (in terms of employment) despite very mild progress on wages, and to the flat consumer price dynamics. This is the aggregate evidence, but it is clear that in some countries, Germany most notably, things are a bit different. InGermany, the increase in real disposable income is due to wages, but this has translated into a quite visible increase in the savings rate.

The other upbeat news is the increase in capital spending, which characterized the second half of 2015 and likely (at least looking at French data) Q1 2016 as well.
But there are a number of headwinds or grounds for headaches, the difference between the two being simply that the latter are more in the vein of risks and hence
their impact is not immediate but dents confidence. If we set aside the banking system issues, which we covered in a previous publication, Navigating European Banking Sector Challenges, we see politics, (including Brexit and Greece) and the fiscal “noise” as the most relevant themes influencing the economic scene and financial markets in the next couple of months.

On politics, broader European issues are interwined with single nation issues (Greece), with the same consequence, of threatening the European political project.
Two big themes falling under “broader Europe” are Brexit and migration. Plenty of analysis on Brexit shows that it will be costly for the UK from a purely macroeconomic (trade related) perspective, and this is becoming more and more clear. It is also clear that the cost for Europe would be the blow to the “Europe project” and its appeal going forward. Prospects for further integration, opt-out clauses, new members – all are at risk of being put into question from a longer-term perspective. The second issue is related to the humanitarian migrants emergency and how to deal with it. Here the question is, once again, the ability to find a common response to an issue that is pan-European by definition but clearly has hit countries in different ways according to their geographical position. And this, once again, has put in question the whole European project.

Main headwinds are political and these forces are putting the EU political project seriously at risk. Consumption is sustained by the positive real income shock due to last year’s fall in oil and commodity prices and by the labour market improvements. Persistent uncertainty on how to deal with structural challenges put the medium term outlook under pressure.

It’s hard to quantify the macroeconomic impact of these issues in the short term, but we believe that if uncertainty regarding how to deal with structural challenges persists, it will pressure the medium term outlook, mainly through the negative impact on confidence.

Brexit: Starting to Bite
Nothing concrete so far, but it is clear that the Brexit story and related uncertainty has been taking a toll on the UK economy. UK GDP growth in Q1 slowed to 0.4% QoQ, down from 0.6% in Q4 2015.While there are no details on the composition of expenditure, we have seen that on the production side only services provided a positive contribution to growth, increasing 0.6% QoQ, while both manufacturing and construction declined.

On the expenditure side we can only infer that the decline in business surveys should be accompanied by a further slowdown in investment spending. It is also clear that the recent weakening of consumer surveys has its parallel in weaker (than last year) consumption. However, overall UK economic fundamentals are good, and if the source of the current uncertainty is removed (i.e. a “remain” vote result), we expect conditions to rebound in the second half of the year.

What are Brexit polls saying? It’s clearly a close call. The polls, at the time of writing, show a very slim distance between the two camps with still 15-20% “undecided” voters. There is an argument that one should take into consideration that the “leave” supporters are likely to be more motivated and hence more likely to actually go and vote on the 23rd of June. What do we expect?We still believe that in the end people in the UK will choose the devil they know (EU) vs the one they don’t know (a protracted period of uncertainty).

This is for a couple of reasons. The first is that, as noted, uncertainty is already biting the economy and we’ve got another month and a half of possible further weakening data. And the second is that the uncertainty ahead of a possible Brexit has a number of dimensions that will become clearer as the vote nears. First of all, on the political front. Mr Cameron as PM and Tory leader will not survive a “leave” vote and, despite the fact that the Labour party is also in a deep crisis, it is clear that a divided Conservative Party would not be good for political stability. Moreover, there is an underlying threat to UK integrity because of Scotland’s clear desire to stay in the EU, which would likely lead to another Scottish Referendum in the event of a “leave” vote.

On the economic side, the consequences are becoming clearer. The HM Treasury released a report with a picture saying “£4300 a year – cost to UK families if Britain leaves EU” after 15 years. The ponderous report (200 pages) says that depending upon the final “distance” from EU (e.g. like Norway, Switzerland orWTO
regulated) the quantified loss for each UK household will be £2600, £4300 or £5200 a year. And the report clarifies that in this first scenario the UK will still have to
accept EU regulations, the free movement of people, and financial contributions to the EU without having any say in policy. The Bank of England May Report came to mthe same conclusions, that Brexit would have material implications on UK economy.

In order to minimize future uncertainty the UK could “leave” just a bit, settling into a position similar to Norway. However, this will bring almost none of the advantages claimed by the “leave” supporters and will require the complicity of the other EU countries, a development that seems quite unlikely on the basis of present posturing. This is particularly true for trade deals, and it is well known that regulatory uncertainty will severely hit Foreign Direct Investments.

But there are also practical aspects which could also create uncertainty: being part of the common market means that a lot of issues in the UK itself are regulated by EU regulations. And it will be extremely complex to legislate all of a sudden on all ofthem.

In conclusion, the situation is still extremely uncertain, with binary outcomes.We see UK financial assets being pressured in the coming weeks. New highs in the costof hedging the British pound are a sign that Brexit is starting to weigh not only on the real economy but also on financial markets.

Greece: Closer to a “Final” Resolution?
Concerns over Greece have resurfaced in the last two months.We heard repeatedly that negotiations were close to a happy ending concerning the first review of the third bailout. The main obstacle (raised by the International Monetary Fund) is the request that the Greek government legislate contingent measures in case the primary surplus target is not met in 2018 (yes, really, 2018, and that number will become known in the first month of 2019, so three years from now); this says a lot about the complexity of the decision-making process on Greece.

There is also a purely political game that seems to be at play: with a mere two seat majority in the Parliament, and with the opposition party New Demokratia now led by a credible leader, it seems that creditors want to test the resolve of the current government in sticking to their requests. However, on the 9th of May, the extraordinary Eurogroup meeting called to discuss the issue came out with an encouraging statement, acknowledging the actions taken by the Greek government (pension reform, personal income tax reform, and additional fiscal parametric measures such as VAT reform and a public sector wage bill) as being substantially in line with the agreements of last summer. The assessment will be finalized in the coming days.

Regarding these contingent measures, it seems that a solution is within reach(binding in terms of amounts, changeable in terms of composition). On debt relief, a sort of schedule has been proposed, including optimized debt management in the short run, a discussion on grace periods and maturities in the medium term, and in the long run, conditional upon compliance with the primary surplus target, possible discussion of further actions on debt. A further discussion will take place on May the 24th, possibly paving the way for a positive solution.

The political agenda is crowded, and not only for Greece. It involves a number of Eurozone countries, in which the results of recent electoral cycles were precarious, notably in Portugal, Ireland and Spain. The latter is to hold a snap election for the first time in its history given the unfruitful election last December. More generally, the problem is the decline in consensus for pro-European traditional parties and the rise in support for new, more skeptical political formations. The next Spanish elections deserve some attention. Polls suggest that if the political scene remains the same, the four major parties (PP, PSOE and the two newcomers Podemos and Ciudadanos) could well end up in another stalemate and have some problem forming a government. But in recent days it seems that Podemos is trying to form a pre-electoral coalition with smaller parties (including those supporting local autonomy). This could change the final result considerably, but again in the direction of Euro skepticism, or at least in a direction not likely to be well-received by markets.

Fiscal Policy: Still Too Timid?
We have highlighted many times that monetary policy alone will not be enough for the global economy to escape the quicksand of low growth and low inflation. Fiscal
policy should support demand in a structural way, but is this happening in the Eurozone?

The overall fiscal policy stance has been defined by the EU Commission in the foreword of its Spring forecasts as slightly expansionary this year and turning neutral the next. The general tone of the report is cautious but not pessimistic. However, this neutrality hides the fact that at the moment three out of the four bigger countries have some quarrel with the paths suggested for them by the EU Commission. More generally, there is an underlying discussion on the form and the substance of the approach to fiscal policy, despite last year’s decisions in the direction of introducing a more flexible approach. France is currently under an excessive deficit procedure and has been asked to rein in its deficit before 2017 (so two years to move from the 3.5% level recorded in 2015 to below 3%); with the EU Commission forecasting a deficit of 3.2% this will not be a long fiscal distance to travel. But 2017 is a general election year, not a situation in which fiscal consolidations typically take place. The political agenda is quite crowded, not only in Greece. A new wave of Euro-scepticism and not particularly market friendly results are the key risks.

However, the more tricky situations are those regarding Spain and Italy. Spain is under an excessive deficit procedure as well, but has been asked to cut the deficit below 3% in 2016. However, final 2015 data showed a very wide slippage of the deficit away from the target of 4.2%, to 5.1%.

In its spring forecasts, the EU Commission has forseen a deficit of 3.9% this year and 3.1% in 2017. The problem is that given Spain’s political stalemate it is difficult to imagine effective action on the deficit. And this is explicitly highlighted by the EU report: “The amount of fiscal policy measures needed to correct the budgetary slippage registered in 2015 add to the downside risks to the growth forecast stemming mainly from the uncertainty surrounding the formation of the new government.”

On Italy, it is clear that the problem is not the deficit, but is rather the stock of public debt and its interaction with the disappointing growth record of Italy in the last 15 years.With the deficit being held below 3% even in recession years, the problem for Italy is hitting the Medium Term Objective of a balanced structural budget and satisfying the rule of reducing debt by a portion of 1/20 of the part exceeding 60% per year. Italy called for flexibility clauses last year and also in 2016; however the budget plan implies a worsening of the structural budget by 0.7% and a tiny decline in debt in the period 2016-2017.

The issues regarding France, Spain and Italy clearly point to a question: is further fiscal consolidation advisable in these three countries? The answer should be that public accounts must be put on an orderly and healthy path of improvement while minimizing any negative impact on the economy. But it is not easy to define rules that allow a case by case approach without raising the suspicion that fiscal policy is no longer “regulated”. Hence, times are probably ripe for a thorough discussion of
the fiscal policy approach in the Eurozone. In the meantime, it will continue to be straitjacketed in a suboptimal way.

The best solution would clearly be the creation of a Eurozone Treasury Minister. But we are a long way from seeing any such solution implemented.

Monica Defend (pictured), head of Global Asset Allocation Research and Andrea Brasili, senior economist Global Asset Allocation Research at Pioneer Investments

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