12 June 2018
By David Palmer, Co-Fund Manager HC Verbatim Portfolio 5 Income Fund
Unravelling the outlook for the single currency region
2017 growth was the Euro area’s fourth consecutive year of expansion since leaving recession behind in 2013. Moreover, 2017 saw the region’s strongest economic growth in a decade, riding a wave of synchronised global growth.
Last year the Euro area grew by 2.5%, and is now just over 6% above its pre-crisis peak. But is this as positive as it sounds? More recent data shows a notable slowdown in the growth momentum.
How can we unpick Europe’s headline growth numbers, and what should investors expect next for the single currency region?
Where have we seen growth so far?
Country by country, Euro area growth has varied. Germany – now more than 10% larger than it was almost a decade ago – has typically led the way, but the laggards are also catching up, with Spain quickly regaining lost ground to be now almost 3% larger than in 2008.
France and Italy also performed better than expected in spite of some political uncertainty, though the latter remains among the weakest economies (still remaining 5% smaller than 10 years ago). Ever the laggard, the Greek economy remains 25% below its pre-crisis peak.
Will monetary policymakers continue to support growth?
The strong pace of growth in late 2017 has showed some signs of easing in 2018, with quarterly growth almost halving in Q1 to a more moderate pace. Temporary factors are likely to have been responsible, including a bad influenza season in Germany, labour strikes in France and unusual weather patterns early in the year.
But while the pace of growth may moderate over the short term, we believe that the fundamental story remains in-tact. The economic recovery supported by easy financial conditions and the need to improve the region’s capital stock after years of weak investment and improved corporate profitability.
Since the European Central Bank (ECB) launched its targeted-long term refinancing operations (T-LTRO) in June 2014, rates on loans to small and medium enterprises (SMEs) are estimated to have declined by around 200 basis points. Given that SMEs provide two-thirds of employment to the Euro area, improving in their funding conditions has been particularly important for investment and employment in the region. Elsewhere in the banking system, loans to non-financial corporates and households are currently running at around 3% – their strongest since 2009, though still well below pre-crisis highs.
From a practical perspective, the central bank’s current quantitative easing programme is due to conclude in September 2018, but we expect that this will be extended for three months at a reduced pace to avoid a ‘cliff edge’ scenario, concluding at the end of December 2018. Put simply, monetary policymakers are expected to remain supportive of growth, with any adjustments carefully calibrated to ensure that the recovery is not prematurely stunted.
Are there any risks to the Euro area growth outlook?
There is certainly some uncertainty surrounding the region’s potential growth rate ahead. The ECB recently revised its potential growth projections upwards to 1.5%, implying a structurally stronger recovery in place. However, this upward revision could instead be accounting for current cyclical factors.
The pre-crisis rate of potential growth is estimated to have been 1.7%, reflecting low productivity, weak reform efforts, and poor demographics. Ahead, the Euro area’s ability to introduce structural reforms to support investment, boost productivity and increase the flexibility in the market for labour, goods and services will be closely linked to the political landscape. Likewise, the prospects for the European Union (given the UK’s eventual withdrawal) could in turn dramatically alter the region’s economic outlook.
Over the past couple of years, robust economic growth has translated into a rise in employment and falling unemployment rates. But underlying inflationary pressures show little sign of picking up materially, especially as wage pressures remain contained. Consumer price inflation has rebounded to around 1.25%, but remains well below the ECB’s target of close to (but below) 2%.
But while the ECB has previously stated that it must see a sustained adjustment in the path of the inflation before ceasing asset purchases, we expect that the central bank’s focus on inflation has lessened more recently. Ahead, it may be that the region’s growth outlook will become the more important deciding factor for the ECB’s policy stance.
Where will growth come from ahead?
Domestic demand is expected to remain as Euro area’s main growth engine. This will be driven by investment and consumption, and bolstered by supportive financial conditions and an improving labour market. Trade should continue to provide a boost to Euro area growth, in line with the global pickup in trade.
We believe that Euro area GDP will come in above potential growth in both 2018 and 2019, at around 2-2.5%, with the remaining slack in the labour market expected to offer scope for growth to continue. Importantly, we also expect that differences between growth in different Euro area economies to narrow.
Overall, with an improving employment picture, a supportive central bank, and a pickup in exports, investors should continue to expect above trend growth for the Euro area over the next two years.
Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. The portfolios' investments are subject to normal fluctuations and other risks inherent when investing in securities.
Verbatim Asset Management has taken due care and attention in preparing this document, which is solely for the use of professional advisers. Verbatim cannot be held responsible for any inaccuracies arising out of information detailed within and will not accept liability for any loss arising out of or in connection with its use.