Is Europe's slowdown really that severe?
Markets are unnerved by a sharp drop in European economic activity and political events – including Brexit – add to the disquiet. But are investors’ fears overblown?
Just as investors were pleasantly surprised by Europe’s robust performance in 2017, so they were dismayed when much of that growth abruptly vanished last year.
This sudden weakness rekindled concerns about the region’s persistent, structural challenges. These are many: lacklustre long-term growth, questions over debt sustainability, ageing populations and numerous political risks – some specific to individual nations and others, such as populism, common across borders.
But how deep is the slowdown? Weakness in the Eurozone, and in particular in its biggest economy, Germany, has arisen largely in manufacturing. This is in part due to industry-specific problems, and partly a response to external demand and so is driven by external factors including, for example, concerns over the China-US trade dispute. Domestic demand, by contrast, is relatively resilient.
We may already have experienced the trough…
Contrary to some in the market, we think the first quarter of 2019 will mark the trough in economic activity in the Eurozone.
Pressure on manufacturing is set to ease. Supply bottlenecks caused by new emission testing standards, for instance, are expected to dissipate later in the year.
Some leading indicators of Eurozone industrial activity, such as the German ZEW survey (a regular poll of leading economists) and the IFO Business Climate Index, bear out our view. They have started to improve from depressed levels.
If global uncertainties fade, trade activity recovers and the Chinese economy enjoys a modest stimulus, the Eurozone is poised to benefit. Domestically, unemployment continues to fall and wage growth adjusted for inflation is on the rise – a favourable combination.
Longer-term problems remain
Europe’s ageing population is a brake on growth into the future. We estimate long-term Eurozone growth will slow to about 1.5% per year from an average of 2% pre-crisis - primarily due to a diminishing labour supply. According to the European Commission, the bloc’s total population is forecast to grow by +0.2% per year over the next decade, compared to +0.5% in the decade to 2018. While immigration is helpful, in theory, rising populism suggests the influx may wane in future years. Given a lack of progress in structural reforms and lower capital investment, Eurozone productivity is unlikely to pick up enough to offset the negative demographic effect.
Lower long-term growth leaves the Eurozone more prone to economic shocks, which in turn feeds investor anxiety. When Italy slipped into recession in the second half 2018 - and Germany teetered on the brink – sentiment was severely shaken.
Lower growth also underscores the bloc’s debt problems, raising the scale of debt relative to GDP and resulting in lower tax revenues. Overall, the Eurozone has a positive primary budget surplus and a modest ongoing reduction in debt to GDP ratio. The ultra-accommodative monetary policy from the European Central Bank is helpful in borrowing costs low.
But there are pockets of weakness: Italy’s public debt trajectory is particularly worrying, for example, as shown in the graph.
Source: Thomson Datastream, Schroders Economics Group
As we expect Eurozone growth to regain momentum in 2019 - and given the long duration of Italy's outstanding debt - the negative headlines to Italian debt may be contained for this year at least.
The problem of politics
With the ongoing “yellow vest” protest in France, Brexit disarray in the UK and the European Parliament elections in May, populism and political risk remain significant concerns. French protests have already been highly disruptive to activity, especially in the services sector, and President Macron’s approval rating plunged to a low of 23% in December.
More positively we have started to see some recovery in his rating following increases to public spending. The violent nature of protests has dented the support of the yellow vest movement. We expect to see the negative impact from the protests to fade in 2019 and consumer confidence to recover. But the chapter highlights the difficulty France faces in implementing structural reforms – which relates back to the problem of lower trend growth across the bloc.
In Italy, 2019 has seen the radical and populist 5Star Movement suffering heavy losses at recent regional elections. Lega, with its more responsible fiscal stance, has gained support. Political uncertainty prevails as Lega’s leader Matteo Salvini may want to consolidate power by calling a snap election this year.
For the European Parliamentary elections in May 23-26, the risk is that anti-establishment parties gain seats, risking disruption to future legislation and budgets. While this is an important political event to watch in 2019 the risks of the EU Parliament going from mainstream to radical is limited.
Political risk is always going to dominate but we think the overall backdrop is less negative now than in 2018. Markets may well surprise on the upside.
And across the channel: Brexit
The UK’s 2018 slowdown was less pronounced than elsewhere in Europe. While there are competing visions of what the UK’s post-Brexit economy should look like, as of today the country is less exposed to global trade than the continent. This has shielded it from some of the headwinds that weighed on Eurozone growth in 2018.
As a result, we expect less of a pick-up in the UK in 2019. Consumer and business confidence could benefit from a Brexit deal, especially if it ended the stand-off between the government and parliament. The UK’s improved fiscal position should also allow for some increase in government spending.
However, any rebound is likely to be modest. Any Brexit deal is likely to include a two-year transition period, suggesting political risk will remain high for the foreseeable future. Secondly, longer-term growth looks set to remain anaemic. Like the rest of Europe, the UK has an ageing population and reduced political appetite for immigration - both of which limit labour supply growth.
We currently see little reason to expect any sharp improvement in productivity, the other key driver of long-term growth. This backdrop makes the UK’s economy even more vulnerable to a protracted period of political uncertainty.
Janet Mui, CFA is the global economist at Cazenove Capital, the wealth management division of Schroders. Janet is responsible for the formulation and communication of Cazenove’s top-down views. She is a member of the investment committee that oversees strategic and tactical asset allocation at Cazenove. Janet is also the macro spokesperson and a regular commentator at major media outlets including the BBC, Bloomberg and CNBC.
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