After Brexit and the US presidential election, a third ballot nightmare materialized in December when the Italian constitutional referendum ended in a wide defeat for Prime Minister Matteo Renzi’s government, with his resignation being the initial consequence. These episodes gave further voice to the centrifugal forces in Europe, and a success for the euro-skeptics in France would be particularly critical, as would a general election in Italy.
There are also a number of Euro or European-wide themes and issues: the issue of migrants is still a source of debate, as is the attitude towards the UK and the Brexit negotiations; the US position towards Russia and sanctions is also in focus, particularly if the Trump administration changes its posture towards Russia and NATO support.
Despite all of these variables, the economy is improving after a soft period in the summer of 2016. Eurozone GDP grew by 0.3% QoQ, 1.7% YoY in Q3 2016, with a good contribution coming from domestic demand (particularly private consumption) and a mildly negative one from net exports. It is likely that growth in 2016 will be at 1.6% even though a more favorable rounding to 1.7% (as in ECB December forecasts) cannot be excluded. In fact, our leading indicator has been rising mildly recently, hence we expect a 0.4% average pace in Q4 2016 and Q1 2017. We expect this pace to be maintained over the foreseeable future with growth at around 1.5% until 2018.
Source: Pioneer Investments on Datastream data, Bank of Italy and CEPR (Eurocoin, a coincident indicator of Eurozone business cycle), Bloomberg. Data as of December 15, 2016. PMI is the Purchasing Managers Index. A reading above 50 indicates an expansion of the manufacturing sector.
In fact, business surveys are pointing up, starting with Purchasing Manager Indices (PMIs) now firmly above 50 for all of the four biggest Eurozone countries. EU Commission survey results are also on the rise (albeit, more on the business than consumer side). Looking at the underlying survey questions, the positive factors behind the rise consistently point to improved “employment expectations” and “price expectations”.
It is possible to interpret these results with some degree of optimism, as the former signals a tendency towards an improving business environment (easier to hire) and the latter suggests somewhat firmer demand that would allow some margin increases (but not in the retail sector).
What is not yet clear is the extent to which the improvements in manufacturing PMI indices are also linked to an upgrade in external demand; but there is a suggestion in this direction.
With the recovery in commodity and energy prices, it is clear that there is a base effect due to the sharp decline in December-January last year that will bring headline inflation above 1%. But headline figures are still anchored to a very low level. Our econometric model projects an inflation rate at 0.2% in 2016, rising to 1.4% in 2017 and 1.7% in 2018, with core rates lagging a bit behind for the entire period, arriving at 1.3% in 2018. Hence, we agree entirely with the ECB analysis suggesting the need to continue accommodative monetary policy.
At its December 2016 meeting, the ECB further extended its Asset Purchase Program (APP) while leaving interest rates unchanged. From April 2017 until at least December 2017, purchases will continue at a €60 billion monthly, adding a further €540 billion of purchases on top of the already planned €1.76 trillion of asset purchases, which are now expected to total €2.3 trillion to the end of 2017. The ECB also adjusted the parameters of its APP to accommodate the further purchases, with the changes taking effect from January 2017. Specifically, the shortest maturity of purchases, allowed at the time of purchase, was reduced from two years to one year; in addition, purchases of assets yielding less than -40 bps yield of the deposit facility will be allowed if necessary to meet the monetary policy objectives. Despite announcing a reduction in the pace of purchases, the ECB sounded the same relatively dovish tone and appears ready to maintain its very accommodative stance as long as necessary.
Concerning fiscal policy in the Eurozone, the graph below clearly indicates a mild tendency towards easing and even the countries that are still in Excessive Deficit Procedure (like Spain and France) are not enacting tough policies. The EU Commission proposed to define a “number” to describe the aggregate fiscal stance and then, in its European Semester Autumn Package, it also stated that in 2017 fiscal expansion by at least 0.5% is recommended for the Eurozone (particular via expansionary actions from countries not at risk of non-compliance, namely, Germany). This proposal has not been well received by the Eurogroup. Hence, nothing particularly tough will be implemented in addition to what the below graph shows.
Change in Structural Budget Balance