Eurozone economic activity falling back towards potential
Weakness in industrial activity, partially reflecting temporary factors such as the implementation of new emission testing procedures in the car industry, and weaker confidence indicators suggest that the pace of economic activity is softening. The latest eurozone PMI data are back at levels last seen in 2016. The European economic cycle has seen solid improvement since the second half of 2016 on the back of ample spare capacity and economic activity is now falling back to growth rates more in line with potential. The eurozone unemployment rate has dropped back to just over 8% and wage growth is finally picking up, implying that underlying price pressures should move somewhat higher from here. That said, headline inflation (now at 2%) will be negatively impacted by base effects related to the evolution of energy prices. All in all, the ECB is still on course to end its asset purchases by the end of this year. But it is still too soon for an actual rate hike. The ECB systematically got its inflation forecasts wrong and the 2% target is still way out of reach. As things stand, the first rate hike will probably not come before September 2019. Italy’s new populist Eurosceptic coalition government will remain a source of uncertainty for both Italy and the Eurozone.
Confidence in Italy has dropped significantly following the elections earlier this year and the budget dispute with the European Commission. Some kind of budget deal looks likely but the more important issue is that economic growth remains hugely disappointing. As such, without further institutional progress in the Eurozone, the country remains vulnerable to periods of self-fulfilling panic reactions in markets. The so-called ‘yellow vest’ protests have forced French President Macron to ease budgetary policy and the budget deficit for 2019 is expected to move beyond 3% of GDP. This is not a huge issue in itself but countries like Germany and the Netherlands are likely to interpret it as more evidence of fiscal profligacy, hindering institutional progress towards more solidarity. Meanwhile, Brexit uncertainty is still huge. But at least, Prime Minister May survived the Conservative Party’s confidence vote. As long as she doesn’t resign, and the Conservatives remain in government, the risk that the party could be led by a hardline Brexiteer for the last few months of the Article 50 withdrawal process is now much lower. While the EU will probably offer guarantees and promises that it will not use the backstop as a tool to permanently trap the UK in the EU customs union, there is very little chance that it will be removed. The question is whether this will satisfy the hard Brexiteers and the Northern Irish DUP. At this point, the current deal is unlikely to pass parliament. Therefore, even though the soft Brexit scenario is still the most plausible one, chances of a hard Brexit remain significant.
