Degroof Petercam: European currency union still faces existential challenges

The European economy continues to grow at a modest pace which is fairly disappointing given several positive elements (low energy prices, accommodative monetary policy and the current low yields environment and EUR weakness) in place. Leading indicators are still in line with expansion of around 1.5%- 2%. This is encouraging after years of standstill though still nothing to cheer about. Indeed, Eurozone economic activity has just pasted its 2008 level. 

What’s more, the upward economic momentum seems to be leveling off according to latest confidence survey data. Finally, it will prove close to impossible for the Eurozone to escape the current global growth deceleration. Therefore, consensus growth forecasts look somewhat too optimistic. It’s not entirely clear at this moment to what extent risks stemming from a few players in the banking sector could spread more widely.

Looking ahead, consumption should continue to increase at a modest pace supported by the slow but gradual improvement observed within the labour market, resilient consumer confidence and low oil prices.

Headline inflation (0.2% yoy in December) is held down by the recent steep fall in energy prices but base effects will send it higher in the second half of the year. Underlying price measures on the other hand remain very weak reflecting the slack in the labor market. Given the persistence of the large negative output gap, core inflationary pressures are expected to stay fairly weak. The ECB is likely to experience major difficulties in getting inflation up to its target of 2%.

Our long-held stance that the ECB would be forced to do more is proven right. In its December meeting, the ECB left the size of monthly asset purchases unchanged at €60 billion but decided to extend is program until March 2017. In addition, the ECB decided to lower its deposit rate by 10 bp to -0.3. In its January meeting, the ECB implicitly committed to do more in March. A further deposit rate cut to -0.4% seems the absolute minimum the ECB will have to deliver next month in order to more or less meet financial market expecations.

The Greek situation remains extremely difficult. Although funding is secured following the agreement reached in July, further imposed budgetary tightening will keep Greece stuck in recession with unemployment and public debt at unsustainably high levels. In this context, political and economic risks will stay high.

In a longer term perspective, European politics remain worrying in the sense that the currency union still faces existential challenges. Further integration, while very much needed, looks far from evident at this point. Both the refugee crisis and rising popularity of extreme political parties in recent years is likely to make things only more complicated in this respect.

The political situation in Spain is now increasingly drawing attention because, unlike in the past, no single party has an absolute majority and forming a coalition is difficult. The ECB’s QE program, however, is likely to prevent that government bond spreads widen sharply. The Catalan issue should not be a major problem at least for now. First, Catalans are highly divided. Second, EU membership would not be possible without all other EU members approving it (highly unlikely).

The Brexit risk is real. Polls suggest opinions are highly divided (latest figures show that ‘leave camp’ is leading). The debate is likely to intensify in the near future. All in all, our scenario is that Brexit will be avoided eventually. That said, risks remain high. This situation once again underlines the very challenging European political context. 

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