The European economy is in pretty good shape. It’s European politics that is causing a headache.
In the past, powerful politicians such as German post-war Chancellor Konrad Adenauer or General Charles de Gaulle have helped define the essence of the European Union. Today, strong European leaders with a clear European vision and the ability to sway public opinion are few and far between.
Although the established parties will in all likelihood prevail over populist ones in the upcoming national elections in the largest EU countries, surprises cannot be ruled out.
The governments of major EU member states aren’t expected to make much effort to promote convergence and reforms in 2017. This is due to the political agenda. General elections in the Netherlands (March), France (April/May, June) and Germany (autumn) stand in the way of any further change.
Each country will have its hands tied until the new government comes into power, which will probably not be until the end of 2017 in Germany’s case. Concerns about political stability in Italy also persist, despite the current “caretaker government”, and could flare up again if fresh elections are called in the summer of 2017.
Even though we do not expect major disruptions to the political landscape by eurosceptic parties such as the Front National in France or Movimento Cinque Stelle in Italy, the respective elections and the mood of uncertainty are likely to fuel regular bouts of turbulence.
The atmosphere of insecurity will also be amplified by the start of Brexit negotiations and concerns about how relations between America and Europe will develop. Britain’s exit will cause the EU political headaches, although the EU has much less at stake.
Already at the start of the year, a number of important political markers are due to be set. In January, Italy’s constitutional court will decide on the legality of the new electoral law Italicum, while Britain’s Supreme Court is expected to decide whether parliamentary approval is needed for Brexit negotiations to go ahead.
Growing divergence within the euro zone
The big problem within the euro zone is the difference in performance between individual member states. For the concept of a united Europe with a single monetary and fiscal policy to succeed at all, these differences need to be resolved.
However, a look at unit-labour costs (see chart 1) reveals that the opposite is happening. Producing the same product in Germany requires roughly 20% higher wage costs than in 1999. In Italy, the increase is as high as 44%, even though unemployment in Germany was around 7.5% compared with almost 9.2% in Italy, which theoretically should have resulted in Italy registering a smaller increase in unit labour costs than Germany.
Meanwhile, unemployment rates should have steadily converged over the period of the past 15 years due to the free movement of labour around the European job market. This has not happened, however. In January 1999, the unemployment rate in Italy was 11.1%, compared with around 9% in Germany. The current rate is 11.6% in Italy, compared with just 4.1% in Germany.
Economic situation favourable despite Brexit fears
At the moment, economic growth in Europe is unexpectedly positive. Despite all the prophecies of doom, the euro-zone economy has been doing well since last June’s Brexit vote. At the end of 2016, leading indicators such as the purchasing manager indices and consumer-confidence barometers were positive. The economic experts polled by the Ifo Institute also gave a very positive assessment of the current economic situation in the euro zone (see chart 2).
Since the start of 2016, however, the experts have become more cautious about their forecasts for the next two quarters. There is a significant discrepancy between the assessment of the current situation and the forecast trend. It therefore looks as though some pundits are viewing the current situation too favourably.
But to end on a positive note, the current upturn in the global economy, emanating from the US and spilling over to emerging-market countries, will be extremely helpful for the euro zone. It should ensure that its economy manages to survive the potential political upheavals – a scenario we think is likely.
Reto Cueni is senior Economist at Vontobel Asset Management