Market-testing the euro area recovery

Euro area financial markets have been affected no less than their major economy peers from the turbulence that has reigned since the start of the year, with equities in a bear market and yields on certain government bonds at new record lows. Thankfully, this time around the sources of current global financial market turbulence – concerns about the competence of China’s economic policymakers and the wisdom of the Fed’s December rate hike combining with a renewed plunge in oil prices – lay beyond Europe’s borders. But investors are well aware that, if market turbulence persists, the economic consequences could yet be significant in the EU, where the economic recovery remains vulnerable, inflation is still too low for comfort and serious political tensions remain dangerously close to the surface.

Admittedly, in recent months, economic data from much of Europe have been as firm as any objective observer might have hoped. Figures to be released on 12 February should show that euro area GDP growth in the final quarter of 2015 was sustained at an annualised rate of around 1½%, thus comfortably outpacing (albeit probably only temporarily) the US. While most sources of demand, including exports and – thanks partly to unseasonably warm weather – construction investment, look to have been a touch firmer than in previous quarters, consumer spending likely remained the principal driver. Despite a slight drop in retail sales in the fourth quarter, the surge in new car registrations in December to the highest level since early 2010 suggested an increased readiness for big-ticket purchases. Indeed, household spending has benefited from rising disposable incomes and a faster-than-expected drop in the unemployment rate, with job growth particularly firm in Spain where labour market reforms are now paying dividends.

The improvement in labour market conditions means that households have not yet taken fright from recent developments in financial markets, although euro area consumer confidence has fallen from the multi-year highs reached in the first half of 2015. But further market turbulence will likely see consumer unease rise. And we are most concerned about how businesses will respond, with surveys signalling a deterioration in firms’ assessments of the economic outlook – in January the German Ifo index recorded the biggest drop in its ‘expectations’ balance since 2012. This increased uncertainty means that, while lower interest rates and more relaxed credit conditions have delivered a pickup in lending to non-financial companies, we expect business investment in the euro area to remain very subdued.

The longer that financial market turbulence persists, the increased likelihood that euro area exports will weaken too. Shipments of goods to the UK and US posted solid growth in 2015. But doubts about the outlook for demand from both countries might increase. Meanwhile, exports to economically troubled China, Brazil and Russia fell last year, and that trend seems increasingly likely to be accentuated in 2016 as painful adjustments continue. And with increased risk aversion, the euro has appreciated significantly in trade-weighted terms, eroding competitiveness. Indeed, perhaps surprisingly, since the launch of QE the euro has appreciated against all major currencies except the yen.

Overall, therefore, recent market events increase the likelihood that GDP growth in the euro area this year will slow, and perhaps markedly so. They are also, inevitably, having a significant bearing on the outlook for inflation. According to the flash estimate, headline CPI rose in January to 0.4%Y/Y, the highest since 2014. But due to the sharp fall in the oil price over the past couple of months, inflation is likely to fall back again close to and perhaps below zero in coming months and average less than half the ECB’s most recent forecast of 1%Y/Y in 2016. With measures of medium-term inflation expectations, which are closely watched by policymakers in Frankfurt, having fallen back near their record lows too, Draghi has had no option but to signal that further ECB easing is likely to come in March.

The timidity of the additional monetary easing announced in December that so disappointed financial markets, coupled with what we have heard from Governing Council members, suggests that a further conservative 10bp cut in the deposit rate to -0.40% is most likely to be on the cards. That would not have a significant economic impact. Other options to be considered by the ECB include an expansion and/or extension of the asset purchase programme and an extension of the TLTRO loan programme, and perhaps even a tiered system of interest rates on bank deposits at the ECB – coupled with a larger rate cut on marginal deposits – akin to that announced by the BoJ at the end of January. The precise mix of policies will depend on the extent to which economic and financial conditions deteriorate between now and the meeting. However, we consider the hurdle to an increase in the ECB’s monthly asset purchase target to be high. And whatever is announced in March seems unlikely to be transformative.

This blog is based on a forthcoming article to be published by NNA.

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