Eurozone: how good can it get?

The eurozone is doing better. In fourth-quarter 2016, there was a real acceleration in both the manufacturing and services sectors. According to European Commission data, both household confidence and business sentiment have improved strongly since mid-2016. Another key point is that several countries are contributing to this movement. Purchasing managers’ indices for the manufacturing sector have hit especially high levels in Austria, Germany, Ireland, the Netherlands and Spain, while in France and Italy, they are also above 50, the level that separates expansion from contraction. In the services sector, the story is the same: the recovery is very broad. As a result, real GDP rose 0.5% in the fourth quarter compared to Q3 (non-annualised rate), and everything suggests that the current quarter will be just as strong.

This dynamic momentum can be attributed to several factors. Externally, the Chinese economy has improved, bolstered by stimulus measures, which has lifted eurozone exports. So far Brexit has had only a limited impact on the UK economy, which is one of the zone’s major trading partners. Other external factors include the prospects of a fiscal stimulus in the US and a competitive euro. In terms of domestic demand, household confidence and the increase in real disposable income is fuelling consumption, while several years of earnings growth and favourable financing conditions are fostering corporate investment.

Yet just how far can this recovery go? According to several variables, there is still the potential to return to past peaks. But that does not mean that they will actually be reached. According to the eurozone bank lending survey, the growth rate of investment is tending to level off. For households, the upturn in inflation, due largely to higher energy prices, will strain real revenue growth and in turn consumption, unless households decide to pour less into savings. Uncertainty surrounding upcoming elections in several countries is unlikely to have a major impact, based on an empirical analysis of this uncertainty and corporate investment. Fiscal policy is expected to make a smaller contribution to growth than it did in 2016. Among international factors, the prospects of US monetary tightening (we are counting on three key rate increases this year) should bolster the dollar through the end of the year, which is favourable for the eurozone. The Trump administration’s fiscal stimulus package is also expected to have a positive impact on the eurozone, although this is more likely to be felt in 2018. All in all, we are looking for eurozone GDP growth of 1.6% this year and in 2018 as well.

But is the eurozone really doing better? Looking beyond the unquestionable improvement in the cyclical environment, we must keep in mind the numerous structural challenges. This non-exhaustive list includes an low potential growth rate, high unemployment in several countries, particularly among youth, high public sector debt, and the urgent need for a capital markets union, to name but a few. Progress in these areas would help the eurozone withstand headwinds to growth, which despite the current optimism, are bound to pick up. Although the exact behaviour of economic cycles might be uncertain, one thing we can be sure of it that recoveries eventually give way to slowdowns.