The euro area remains in the second-deepest recession of its short history. Despite the emergence of a handful of “green shoots”, such as a pick-up in industrial activity and exports in certain countries at the start of the second quarter, sentiment remains subdued, credit conditions tight and the global backdrop weak. Against this background, following the disappointing contraction in the first quarter, we have revised down our growth forecast for the euro area (see footnote 1) for 2013 to -0.7% from -0.5% previously (see Table 1).
The full-year decline in GDP mainly reflects the impact of continued weak private consumption, expected to contract by 0.7%, after a fall of 1.3% last year, and a further reduction in investment, by 4%, amid low capacity utilisation and weak expected demand. Public consumption, meanwhile, is predicted to decline by 0.2%, reflecting the continued impact of governments’ efforts to rein in spending. Given this, net exports, yet again, will be the only positive contributor to growth in 2013, with exports expected to rise by 0.7% and imports to fall by 0.9%. In this environment, CPI inflation should average just 1.5% this year from 2.5% last year, also reflecting low wage growth in large parts of the single currency area.
Economic weakness will also prevail in 2014 in large parts of the core as well as the periphery. We now expect GDP in the currency area to expand by just 0.7% next year, compared to our previous forecast of 1.0%, reflecting a moderate pick-up in private consumption (+0.2%) and investment (+0.3%) and another sizeable contribution from net exports. This will be less than required, however, to help bring unemployment down from the peak of 12.5%, which we expect to be reached by the end of 2013. CPI inflation, meanwhile, should fall further to average 1.3% next year, supporting the case for further ECB policy easing.
In more detail, our updated growth forecasts reflect downward revisions to growth for both the core (see footnote 2) and the periphery [(see footnote 3) (see Tables 2 and 3)]. In the core, where the pace of contraction accelerated at the start of the year to -0.5%Y/Y from -0.2%Y/Y, we now expect the first full-year decline in 2013 in four years, with GDP predicted to contract by 0.1% (previously +0.1%). This reflects small downward revisions, by 0.1ppt, to growth this year in Germany (+0.3%), France (-0.2%), the Netherlands (-0.9%) and Austria (+0.2%) and more sizeable amendments, by -0.5ppts, to our growth forecasts for Belgium (-0.2%) and Finland (-1.0%).
Part of the downward adjustment for this year reflects disappointing growth outcomes in the first quarter, in particular in Germany, Belgium and Finland, while contractions in France and in the Netherlands were in line with our expectations. But economic weakness is likely to have extended into the second quarter in most core economies as reflected in recent weak export, production and/or sentiment data in France, Belgium and Finland.
In Germany, meanwhile, the most severe floods in a decade in June adversely affected both the services and manufacturing sectors in large parts of the country, pushing our expected growth in Q2 down to 0.2%Q/Q. But we expect growth to accelerate to 0.6%Q/Q in Q3 on the back of expected reconstruction measures and the replacement of damaged durable consumer goods. Indeed, the German government last week announced an emergency fund for reconstruction measures worth €8bn, which will be fully debt-financed and should be in place by 5 July.
The downward adjustments to our growth forecasts for the euro area’s core, however, are more marked for 2014. We now expect growth in the core of just 0.9% next year, down from 1.3% previously, reflecting the combination of a softer-than-expected global backdrop and structural adjustments. In particular, export-orientated economies like Germany and Austria will suffer from weaker-than-expected world trade growth, now forecast by the World Bank to expand by 5.0% in 2014 from 6.7% previously amid subdued global GDP growth of just 3.0%. In this environment, we expect Germany and Austria to expand by 1.3% and 1.2% respectively in 2014 down from our previous forecasts of 1.7%.
Weakness in other core economies, meanwhile, is of a more structural nature. France, the Netherlands, Belgium and Finland all suffer from overheated housing markets, a marked loss in price competitiveness vis-à-vis Germany since the start of monetary union and rising unemployment. None of these developments are as threatening or destabilising as in the periphery. But they will remain a drag on growth by suppressing confidence in the near term. As a result, growth in these economies will remain weak in 2014, with GDP expected to expand by just 0.8% in Belgium, 0.6% in France and 0.4% in the Netherlands and Finland.
For the periphery, meanwhile, we have revised down our growth forecast for this year to -1.8% from -1.5% previously, mainly reflecting a marked change in our outlook for Italy, where we now expect a contraction in GDP of 2.0%, more marked than our previous forecast contraction of -1.5%. This reflects both the sharp fall in GDP in the first quarter, by 0.6%Q/Q, and the unsatisfactory response of the Italian government to the economy’s massive structural challenges. Italy is the only peripheral member state where unit labour costs have continued to increase since the outbreak of the euro area's debt crisis despite a sharp rise in unemployment, mainly reflecting the continued unwillingness of successive governments to tackle vested interests. Given this, and amid a widening fiscal deficit, we expect the Italian economy to virtually stagnate next year (+0.2%), possibly spurring renewed concerns about the sustainability of Italy’s massive debt burden.
In contrast, we have not changed our view on the Spanish economy, for which we still expect a contraction in GDP of 1.4% this year. While the challenges in Spain remain massive amid a record unemployment rate of 26.8% in April and a fiscal deficit expected to remain close to 6% of GDP next year, unit labour costs have fallen by 10% from their peak, the repair of the banking system is progressing despite rapidly falling property prices (30% from the peak) while industrial orders, both domestic and foreign, surged in May. And so, if the government remains committed to its wide-ranging reform agenda, Spain should return to positive growth of 0.5% in 2014.
In the rest of the periphery, meanwhile, developments are broadly as expected. Although sentiment has improved notably in recent months, Portugal and Greece will remain in deep recessionary territory through 2013, with GDP expected to decline by 2.8% and 3.7% respectively. Next year the contraction will moderate, to -0.7% in Portugal and to -0.6% in Greece, but growth in these two economies will critically hinge on their ability to broaden their export capacity amid recent cost competitiveness gains and weak domestic demand. For Ireland, meanwhile, we have lowered our growth forecast to 0.8% this year from 1.0% previously against the backdrop of slower world trade growth. In 2014, growth in Ireland should accelerate to 1.3%.
Despite these expected improvements in economic conditions in the periphery, however, the significant upward shift in global bond yields seen over the past six weeks highlights the continued vulnerability of these economies to maintaining market access in a sustainable manner. So, despite success in tapping capital markets earlier this year, we still have considerable doubts about the ability of Portugal and Ireland to graduate from their bailout programmes in 2014. And with foreign investors having started to withdraw funds from Spain in February and March after receiving net inflows worth 6% of GDP over the previous five months, pressure on Spanish yields might well rise again later in the year if domestic investors are unable or unwilling to meet the government’s large remaining financing needs. Indeed, by mid-June the Spanish Tesoro had still raised less than half of its full-year gross issuance target for medium and long-term bonds, leaving a financing gap of around €70bn for the rest of the year, more than twice the amount purchased by Spanish banks since the beginning of the year (€26bn from January to April). And so, against the backdrop of continued fragile economic fundamentals, we do not rule out the re-emergence of market stress later in the year, possibly forcing Spain and/or Italy to test the ECB’s OMT programme.
Table 1: Euro area: Economic forecasts*Year-end values for unemployment and USD/EUR. Source: Daiwa Capital Markets Europe Ltd.
Table 2: Daiwa forecasts by member state
Source: Daiwa Capital Markets Europe Ltd.
Table 3: Economic forecasts by different institutions
Source: Daiwa Capital Markets Europe Ltd.
1. The euro area aggregate refers to the EA12 excluding Luxembourg. We do not forecast Slovakia, Slovenia, Malta, Cyprus and Estonia.
2. The core includes Germany, France, the Netherlands, Belgium, Austria and Finland.
3. The periphery includes Italy, Spain, Portugal, Greece and Ireland.
Tobias S. Blattner, Euro area Economist