It is more than a year now since the euro area economy returned to growth. And we expect the recovery to continue over coming quarters too. Despite a softening of sentiment in many member states in June, our latest euro area GDP forecast shows a gradual strengthening of quarterly growth to result in an annual rate of 1.1% in 2014, rising to 1.7% in 2015, very similar to the ECB’s current forecasts of 1.0% and 1.7% respectively.
Euro area better placed for growth
While growth of 0.2%Q/Q in Q114 made for a weak start to the year, this was unduly influenced by weather and tax effects, which will also have had some repercussions for Q2 growth. As such, risks to our central growth estimate of 0.3%Q/Q for the past quarter appear higher than usual. But, looking through recent volatility, we continue to expect the euro area to move gradually towards GDP growth rates of around 0.4%Q/Q in the quarters to come as the fallout of the crisis continues to fade and gains in domestic demand become increasingly self-sustaining. A modest easing of credit conditions in countries where they are currently acting as a binding constraint on demand should also give a further boost. And the resulting pace of expansion should help gradually to reduce some of the sizeable slack that still exists.
National growth becoming less divergent
Our forecasts show a relatively bright German and Spanish growth outlook. And while Italy and France are likely to remain less dynamic, growth rates among the member states should become less dispersed (see table):
- Germany’s growth outlook remains bright, despite an expected temporary slowdown in Q2 partly reflecting payback from firmer growth in Q1 due to the warm winter weather. A construction surge inflated first-quarter growth by as much as ¼ppt, causing a broadly commensurate reduction in Q2 GDP growth relative to its trend. Given the cause of the moderation, expected GDP growth of just 0.3%Q/Q in Q2 is not a cause for concern. And with conditions in place for domestic demand growth to gain a boost from both household spending and investment, growth rates are set to recover again from H214 onwards.
- With output in France near-stagnant over recent quarters, a range of sentiment surveys suggest little near-term momentum. However, Q2 growth likely benefited from the fading of Q1’s consumption weakness caused by the VAT hike at the start of the year. And while poor external competitiveness suggests that an export-led recovery will remain elusive, firmer domestic demand, supported by resilient household income and tax measures to business investment, should lift GDP growth to around 0.3%Q/Q by year-end.
- In Italy, the second quarter saw the most buoyant consumer and business sentiment readings for years. And so we expect to see firmer growth after a modest contraction in Q1, when activity was dragged down by a large fall in fixed investment. And with household and government spending trends also generally supportive of GDP growth, we expect the turnaround in confidence to lead to the country’s firmest growth rates since 2010.
- The Spanish economy’s recovery has already gained pace over the past quarters, and recent data and surveys suggest that, following years of painful adjustment, the economy should maintain, if not surpass, Q1 growth of 0.4%Q/Q over coming quarters. With labour and housing markets starting to improve, we expect increasing support from household spending and construction to underpin relatively solid growth this year.
- The Netherlands should see significant positive payback in Q2 following the previous quarter’s extraordinary contraction of 1.4%Q/Q that was due to low gas consumption and exports. With those one-off factors reversed in Q2, we expect GDP growth of around 1½%Q/Q in the past quarter to provide a noticeable lift to euro area GDP overall. With house prices having stabilised, a long-awaited economic recovery in domestic demand should begin to solidify in coming quarters, generating quarterly GDP growth of around 0.3%Q/Q.
Inflation to remain too low
Following recent repeated downside surprises to inflation, we expect the impact of one important source of weakness – food and energy prices – to fade over the coming months. As a result, we expect to see a first significant pick-up in the headline rate from June’s 4½-year low of 0.5%Y/Y to occur in October, when we forecast CPI to rise to 0.8%Y/Y, before inching up further over the following quarters.
But in the absence of a much weaker euro, core inflation, which also declined significantly over the past 18 months, is likely to remain subdued even throughout next year. We do, however, eventually see more positive wage developments in some parts of the euro area, not least Germany, lying ahead. And with the euro area recovery set gradually to gain pace, we expect underlying inflation to slowly pick up during 2015 as spare capacity is slowly reduced. But, on average, inflation next year might be barely more than half the ECB’s 2% target ceiling.
Downside risks predominate…
Perhaps unsurprisingly given the sluggishness of the economic recovery to date, and some recent softer data and surveys, the risks to our forecasts are skewed to the downside. Certainly, there is no shortage of factors – whether high unemployment, elevated borrowing costs, and continued fiscal tightening in the periphery, or the German private sector’s traditional unwillingness to spend – that might continue to weigh on domestic demand more than expected. And, with exports likely to remain an unreliable source of demand – particularly for France and Italy – it is not far-fetched to imagine the euro area economy failing to reach the ‘escape velocity’ recently attained in the UK for several years to come.
…so don’t rule out further ECB action
Risks to our inflation forecast might appear broadly balanced, with a potential escalation of geopolitical risks having the ability to raise energy prices and adverse weather having scope to push food prices higher too. But price pressures from the demand side could well weaken further too. And while the ECB is currently preoccupied implementing the multiple measures announced in June, should that downside scenario – or any other – materialise, we would certainly not exclude it from eventually taking further action, including an asset purchase programme, to try to ward off the risks of a Japan-style accidental slide into deflation.
Euro area macroeconomic forecasts
Daiwa forecasts in italics. Source: Eurostat and Daiwa Capital Markets Europe Ltd.
Euro area: Economic sentiment and GDP growth
Golden bars indicate Daiwa forecast; Source: Datastream and Daiwa Capital Markets Europe Ltd.