Eurozone to rebound on domestic and China stimulus

Despite lagging the global recovery outlook is good


The flash GDP data for the eurozone published last Tuesday came as something of a relief, showing growth of 0.4 per cent on the quarter (1.5 per cent annualised) — considerably better than seen late in 2018. While these numbers have put to bed the exaggerated recent fears of an imminent recession, there is still a lot of gloom about European growth prospects in coming quarters. The ECB, for example, has left the risks to its overall growth outlook tilted to the downside.

This degree of pessimism is probably overdone. Stimulus is coming: from a progressive shift towards more expansionary fiscal policy in the three major economies in the eurozone, and from the lagged effects of the Chinese policy injection, which have not yet been transmitted as far as Europe.

These domestic and foreign fiscal effects, taken together with the large easing in global financial conditions that has followed the co-ordinated shifts in central bank policy, could boost eurozone GDP growth a full percentage point by the year end.

This will be an important support for global risk assets. In fact, it is becoming critical, now that the Federal Reserve has tilted back towards a less dovish policy stance, based on increasing confidence that global activity is about to pick up. If the eurozone disappoints, then the low world growth rate could unhinge the markets.

Recent eurozone activity data

GDP growth at 1.5 per cent in the first quarter of 2019 was slightly above the 1.2 per cent underlying trend rate, and also above the 0.8 per cent seen in the final quarter of 2018.

Although this seems reassuring, the Fulcrum nowcasts since the turn of the year have remained somewhat disappointing. The latest reading shows the activity growth rate at only 0.6 per cent, compared to a low point of 0.2 per cent in January. The global growth rate has jumped by almost a full point over a similar period. For now, the eurozone, and especially its manufacturing sector, remains a laggard amid better global growth rates.

However, two major supports for Eurozone growth are now around the corner.

Support from Eurozone fiscal easing

One of the dominant factors in the global economy last year was the Trump fiscal stimulus in the US, which amounted to 1.2 per cent of GDP over 2019 and 2020. Although US fiscal events are carefully watched by the markets, the same is not always true of Eurozone fiscal policy, where news arrives in a series of disparate announcements in several national jurisdictions, rather than in a single budget for the entire bloc.

Nevertheless, there are some important moves happening in the Eurozone’s likely fiscal stance for the next two years. This will not be on quite the same scale as the stimulus from the Trump package, but it might add up to about half of that amount.

There are three main factors driving the overall Eurozone stimulus.

  • First, while Germany is maintaining its official objective of a balanced budget in the medium term, it is likely that a discretionary fiscal thrust of around 0.8 per cent of GDP will be possible this year, with tax cuts and expenditure increases being announced within that broad objective.
  • Second, President Macron in France has now responded to protests by the gilets jaunes movement by reducing taxation, with any offsetting cuts in public expenditure looking highly uncertain in both scope and timing. The resulting easing in the overall fiscal stance may be around 0.4 per cent of GDP this year.
  • Third, in Italy, the populist coalition has dropped its plans to abandon the EU’s fiscal rules, but an injection of around 0.5 per cent of GDP still seems likely this year.

These changes could boost Eurozone activity growth by at least half a percentage point by the end of 2019.

Lagged support from China

A similar sized boost is on the way from China.

This may surprise investors, because Eurozone activity data have so far failed to respond to the easing in Chinese fiscal and monetary policy. As the box below shows, the sharp recovery in the Chinese nowcast “should” have led to a rise of about 1.3 per cent in German growth, and about 0.6 per cent in Eurozone growth indicators.

This has not happened, leading to suggestions that the size and composition of the Chinese stimulus will have much less dramatic effects on the eurozone economy than the last stimulus package in 2016.

According to investigative econometric work by the excellent Sven Jari Stehn and team at Goldman Sachs, China’s latest stimulus package is around one-third as large as in 2016, and is directed more towards infrastructure and consumer spending than the credit injection three years ago.

This form of stimulus is likely to have a smaller effect on German and other Eurozone manufacturing output. Nevertheless, Goldman Sachs reckons that the total effect of the Chinese stimulus will be to boost Eurozone activity growth by 0.6 per cent by the end of 2019, once the lags have fully worked through. This is similar to the Fulcrum estimates.

As Sven Jari Stehn says: the Chinese effect is not that different this time.

Eurozone does not yet reflect Chinese recovery

The Fulcrum nowcast system allows us to estimate what “should” be happening to eurozone activity growth rates, given the strong pick up that is now under way in the China nowcast.

Based on simulations by my colleague Alberto D’Onofrio, eurozone growth is around 0.6 per cent below where it “should” be, given Chinese growth, and the gap in Germany is even larger, at around 1.3 per cent.

Although this could be the result of idiosyncratic downside shocks to activity in Europe, we interpret much of it to the operation of lags, identified in the work of Goldman Sachs, in which case growth in the eurozone should rebound fairly soon. The full monthly report on the nowcasts is attached here.

Source: This note is based on material which appeared in an article by Gavyn Davies published in the Financial Times on 5 May 2019.
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