European Economic Outlook

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Over the course of the summer, the eurozone economy shrugged off the uncertainty of a potential ‘Grexit’ and the slowdown in emerging countries. Falling commodity prices, coupled with a nascent recovery in employment and record low interest rates, have been a boon for consumers, who are spending their windfall.

However, companies’ costs have fallen far less than households’ because of sticky wages, sluggish productivity and rising import costs caused by the weak euro. And consumers remain price sensitive, putting firms under intense pricing pressure, as the downward inflation trend testifies. Profits are thus still close to an all-time low, relative to GDP, and investment remains weak.

The hope is that as consumer spending fills order books, firms will regain pricing power and can rebuild margins. However, weak global growth makes us sceptical that such a virtuous cycle has time to take hold.

The European Commission has been flexing every possible fiscal rule, effectively removing its scrutiny of members’ deficit misdemeanours. With quantitative easing (QE) cutting interest payments substantially, government spending is expected to continue supporting growth in the near term. But expansion in the public sector makes it harder to cut the – very high – taxes and that may even further depress corporate willingness to invest.

The slowdown in Chinese demand for global commodities is rippling through emerging economies. We forecast emerging-world GDP growth will be weaker in 2016 than at any point since 2009. There are signs US activity is also weakening and the slowdown elsewhere is likely to be seen more clearly in the eurozone economy in the coming quarters.

We recently cut our GDP forecast for Germany from 1.7 per cent growth in 2016 to 1.4 per cent with France lowered from 1.4 per cent to 1.1 per cent. But we upgraded Italy to 1.0 per cent and Spain to 2.3 per cent, so our 2016 forecast for the whole eurozone has remained 1.4 per cent when other parts of the world were being revised down.

Our main downward revisions have been to inflation. We are concerned that once the oil windfall is spent, the eurozone will again settle into a prolonged period of sluggish growth and uncomfortably low inflation with ever rising government debt.

Despite low lending rates and credit expansion, inflation is still way off target. Inflation should blip up around Christmas, but is likely slip back again in the early months of 2016.

The European Central Bank faces considerable technical constraints on the size of its QE programme that politically will be hard to overcome. We expect the ECB to continue the EUR60 billion a month programme beyond September 2016. But if the global economy fails to gather steam, its limited firepower may be unable to defend the euro and meeting the inflation objective could prove mission impossible.