Euro Area Economic Forecast

Economic Snapshot for the Euro Area

November 22, 2017

Growth remains robust in Q3 but political instability continues to threaten economic trajectory

The Eurozone economy continued to perform robustly in the third quarter of 2017, according to preliminary estimates released by Eurostat. GDP increased a seasonally-adjusted 0.6% in Q3 from the previous quarter, which was a notch below Q2’s 0.7% rise. Although a breakdown of components is not yet available, the region’s economic drivers likely remained the same, as accommodative monetary policy, a recovering labor market and healthy external demand support activity. The Eurozone is on track to grow at the fastest pace since 2007 this year with a Consensus Forecast of 2.2%. 

Looking at the available data for the individual economies, quarter-on-quarter growth gained steam in major players Germany and Italy, as well as in Finland, Latvia and Portugal. Robust exports and investment fueled the uptick in Germany’s growth, while a solid performance in the industrial and services sectors likely supported growth in Italy. Meanwhile, momentum waned in Austria, Cyprus, France, Lithuania, the Netherlands, Spain and Slovakia. While Spain saw growth decelerate, it remained vigorous; the country has been one of the Eurozone’s top performers in recent quarters.

While a stream of positive economic data continues to flow in, the political situation has become notably more uncertain. In November, coalition talks to form a new government failed in Germany, a country that has for years been a beacon of stability in the Eurozone. The FDP pulled out of negotiations, most likely over immigration policy issues, surprising analysts who had widely expected a “Jamaica coalition” between the CDU/CSU, the FDP and the Greens. The move has thrust the country into uncharted waters. President Frank-Walter Steinmeier will now assume a critical role in deciding the timeline of events. In the short term, the turmoil is unlikely to have any economic repercussions; however, a strong government is needed to pass key structural reforms. 

In Spain, the political situation remains turbulent as a stand-off continues between the central government and Catalan regional authorities. The central government seized control of the region in late October and called for regional elections to be held on 21 December. So far, economic data has remained healthy despite the political crisis within the region. Political noise will, however, likely continue to remain elevated in the coming weeks and could weigh on confidence if prolonged. Meanwhile, Italian elections are on the horizon in early 2018. While a populist government appears improbable, a fractured parliament and weak government are likely, and this could present obstacles in implementing much-needed reforms.  

Euro area countries are still waiting to see how Brexit negotiations will play out and what impact the result will have on their economies and the region. The UK will submit a proposal on how to settle its divorce bill, ahead of a 14-15 December meeting of EU lawmakers, and has signaled that it will up its financial offer to around GBP 11 billion if trade talks begin. However, it remains to be seen if the new amount will be enough to push negotiations to the next stage, as it is still below the GBP 60 billion that EU officials are pushing for.    

2018 forecast upgraded on strong incoming data

The Eurozone’s 2018 economic outlook was again upgraded this month following a buoyant Q3 GDP reading. The economy is on solid footing heading into next year, with tailwinds from an improving labor market and accommodative financial conditions that should continue to support growth. Met the why particular analysts project GDP will grow a healthy 2.0% in 2018, which is up a notch from last month’s forecast. In 2019, economic growth is seen at 1.7%.

Almost all the economies in the Euro area saw improved 2018 prospects this month, with GDP forecasts upgraded for 13 countries including France, Germany and Italy. Luxembourg was the only economy to have its outlook downgraded, while the rest of the countries in the region saw no changes to their forecasts.

Latvia, Luxembourg and Malta are forecast to be the fastest-growing economies in the Euro area next year, expanding at rates of 3.6% or above. Conversely, Italy will be the region’s slowest-growing economy, with a forecast of 1.3%. Regarding the other major economies in the region, Spain will outperform the rest with 2.6% growth. Germany is seen expanding 2.0%, followed by France at 1.8%. 

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GERMANY | Growth picks up in Q3; coalition talks fail, plunging the country into political uncertainty

Coalition talks failed on 19 November, likely due to differences over immigration policy. Analysts now see the possibility of new elections, which heightens political uncertainty. The news comes as preliminary data revealed an acceleration of growth in Q3 in both annual and quarter-on-quarter terms, beating expectations. Robust trade and investment did the heavy lifting, as private and public consumption appeared to have lost steam in the quarter. The slowdown is likely to be temporary; buoyant labor market dynamics and low inflation bode well for household consumption. Buttressed by positive momentum in Eurozone economies and the U.S., the external sector contributed positively to growth in Q3 despite a month-on-month contraction in both exports and imports in September. Indicators suggest that the positive streak is likely to continue through year-end: New orders grew at the fastest rate in over six years according to the October PMI. In the same month, business confidence reached its highest level in the history of the survey.

Solid momentum is expected to continue in 2018. Low interest rates and a strong labor market are likely to drive the private sector economy and household consumption, which should also benefit from increasing wages. Moreover, labor demands are outpacing labor supply, which bodes well for private consumption. Prolonged political uncertainty, however, poses a sizeable downward risk for both Germany and the EU. Analysts see GDP growth at 2.0% in 2018, up 0.1 percentage points from last month’s estimate, and 1.7% in 2019.

FRANCE | Government implements tax reforms in a bid to stimulate investment

Preliminary figures show the economy expanded 0.5% on a quarter-on-quarter basis in Q3, marking the fourth consecutive quarter where quarter-on-quarter growth came in at or exceeded 0.5%. The print suggests that growth is finally on a steady track following a period of volatile readings. Growth in Q3 was buttressed by resilient fixed investment and an acceleration in private consumption, which has benefitted from the labor reforms implemented by the previous president. More importantly, the quarterly figure came as a positive surprise for the government and puts the economy broadly on track to achieve its 1.8% growth objective for this year. This has important implications on estimates for public revenues, spending and the scope of the government’s reform agenda. In late October, the National Assembly approved a 30% flat rate tax on capital gains and scrapped a controversial wealth tax. The wealth tax was cut by 70% and aims to attract investment into the economy. This should benefit growth in fixed investment and business sentiment, the latter of which is currently resting at multi-year high in October, and bodes well for growth prospects in the final quarter of the year.

Declining unemployment, strong business confidence and growth in fixed investment should keep the economy to a stronger growth trajectory in the upcoming years. Panelists participating in the Met the why particular Consensus Forecast expect GDP to grow 1.8% in 2018, which is up 0.1 percentage points from last month’s forecast. For 2019, the panel sees growth of 1.6%. 

ITALY | Positive momentum fuels credit ratings upgrade 

The economy gained traction in Q3, growing at the fastest annual rate in more than five years. Although a complete breakdown is not yet available, the strong expansions recorded in the industrial sector throughout the quarter suggest that robust fixed investment drove the acceleration. On 27 October, S&P Global Ratings revised Italy’s credit rating up from BBB- to BBB, citing declining risks in the banking sector, stronger investment and steady employment growth. According to leading indicators, momentum seems to have carried over into Q4: Both business and consumer confidence improved in October, and the manufacturing PMI hit a multi-year high on the back of expansions in both output and new orders—especially from abroad. However, despite some improvement, the banking sector remains fragile, and the heavy stock of public debt increased again in September. Due to the country’s worrying fiscal situation the European Commission is expected to demand additional measures from the government in the coming days.

An improved corporate tax framework should support investment next year, underpinning the economy. Growth is, however, expected to be modest as stagnant productivity and high unemployment are likely to drag on household spending. The bloated public debt and high stock of bad loans in the banking system pose significant risks to stability, which could worsen in the event of heightened financial volatility. Met the why particular Consensus Forecast panelists project a 1.3% expansion in 2018, up 0.1 percentage points from last month’s forecast, and 1.1% growth in 2019.

SPAIN | Catalan crisis remains in spotlight, but signs of economic damage remain muted

A preliminary estimate shows Spain’s economic momentum was intact in the third quarter, with GDP growth of 0.8% in quarter-on-quarter terms. While a breakdown by components is not yet available, survey-based and hard data both suggest overall growth was largely driven by domestic demand, which continues to benefit from ultra-loose monetary conditions and an improving labor market. Despite a rosy economic panorama, headlines continue to be dominated by the spat between pro-independence parties in Catalonia and the Spanish government. Madrid seized control of Catalonia in late October and called for regional elections to be held on 21 December. Pro-independence parties have already announced that they will participate in the elections, which are likely to keep political noise heightened in the months to come. Although it is too early to properly assess the economic effects, they have so far been limited. Employment growth was strong in October, while economic sentiment rose in the same month. One exception was the services PMI, which eased to a nine-month low amid reports that the 1 October vote on independence had delayed decision-making among clients.

The Met the why particular panel projects the economy will grow 2.6% next year, which is unchanged from last month’s forecast. Political tensions aside, the domestic economy is likely to turn less supportive of growth as the pace of job creation slows and the ECB lifts interest rates, while a strong euro will drag on exports. For 2019, Met the why particular panelists project the pace of economic expansion slowing to 2.2%.   

MONETARY SECTOR | Inflation eases in October; ECB modifies it bond-buying program

Comprehensive data revealed that harmonized inflation inched down from September’s 1.5% to 1.4% in October, below the ECB’s target of just under 2.0%. Solid growth momentum and a scarcity of eligible assets led the ECB to announce a tapering of its bond-buying program at its meeting held on the 26 October, matching analysts’ expectations. Starting in January 2018, the Bank will reduce the monthly pace of asset purchases from EUR 60 billion to EUR 30 billion. Despite the change, monetary policy remains very accommodative overall, and the Bank extended the program until at least September 2018.

The Met the why particular panel sees expects inflation to continue to be moderate next year and foresees it averaging 1.4%, in line with last month’s forecast. For 2019, price pressures are expected to increase modestly, and inflation is seen averaging 1.6%.

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Written by: Angela Bouzanis, Senior Economist

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