Raising the bar
25 July 2017
So far, 2017 has been a good year for the Eurozone. On balance, both the hard and soft data through the first six months reflect a continuing strengthening of the economic recovery against the backdrop of the global cyclical upswing. At the latest count, industrial production had risen 4% in the year to May; the unemployment rate is at an eight-year low of 9.3% and; as of Monday, the IMF upgraded its growth forecast to 1.9% from 1.7% in April, citing greater-than-expected domestic demand in the first part of the year. Can the second half of the year live up to the standards set in the first half? The July EC business and consumer survey highlighted that expectations for consumers, who drive domestic demand, remain high for the coming 12 months, both in terms of their own financial and the more general economic situation; however, weak real wage growth may limit this exuberance. Manufacturers highlight rising order books and employment expectations, while business expectations among retailers, construction companies and services firms show no signs of deflating.
However, this strong growth has not been matched by firming inflation. This disconnect has created a bit of a quandary for policymakers at the ECB, with recent communications illustrating the sensitivity of markets to the possibility of tapering the asset purchase programme. How can the ECB steer through this tricky patch? Last week’s ECB meeting minutes provided interesting food for thought. The Governing Council’s comments were a near-carbon copy of the previous ECB meeting, stressing the ongoing strengthening of the Eurozone recovery but notable absence of rising cost pressures – with the tone here slightly more cautious than that taken by Draghi in his recent Sintra speech. This time, Draghi was keen to stress that precise asset purchase changes won’t be discussed until some time in the autumn and stressed that the Council can find flexibility if conditions demand a purchase programme extension. That said, while bond markets reacted favourably to the return of a dovish tilt, euro strengthening on the day of the Q&;A suggests that currency markets aren’t buying it (see Chart 5). This appreciation will not be welcomed by Draghi and underscores that the path to tapering will be a difficult one to tread through the rest of the year.
At the start of 2017, the Eurozone was facing significant eurosceptic political risk from major Dutch and French elections, as well as the possibility of early Italian elections. Both the Dutch and French elections passed without major incident, mechanically reducing the probability of a market-destabilising political event in the Eurozone. However, attention will naturally turn to Italy in the coming months: in such a fractured and polarised political system, our risk analysis reflects that whenever this election is held, uncertainty is likely to be high in the run-up and even afterwards (see Chart 6). While, generally speaking, the eurosceptic risk has temporarily waned, mainstream politicians – particularly in France and Germany – must build policy that addresses the issues that lead disenfranchised voters to vote for populist parties. The migrant crisis presents just such an opportunity, with Italy bearing the brunt of arrivals. Hopes were high that Macron would influence change at the European policy level but thus far, Italian authorities have been disappointed by a lack of action on this front.