UBS: Eurozone: strong finish to 2016, good start to 2017

Resilience continues, PMIs at multi-year highs

Business confidence has risen well above pre-UK-referendum levels – despite the uncertainty around Italian banking sector challenges and important European elections this year. We see possible upside risk to our Eurozone GDP growth forecasts of 0.3% q/q, 1.5% y/y for Q4-16.

While this might not affect our 2016 growth assumption of 1.6%, it might – via ahigher statistical overhang – imply upside risk to our 2017 GDP forecast of 1.3%.
Domestic demand still strong, external outlook perceived to be improving

What explains this resilience? Extending a well-established trend, domestic demand has remained resilient so far, due to improving labour markets, decent real wage growth, somewhat stronger fiscal policy, and ongoing support from the ECB. And recently, export expectations have improved a lot, presumably due to expectations for reflation scenarios in the US and somewhat brighter prospects for EM. This also explains why Manufacturing PMIs have recently risen above Services PMIs.

Short-term outlook constructive, but domestic demand to weaken over time

Where to from here? We maintain a constructive growth outlook for the monthsahead, but think that the strong support that Eurozone domestic demand enjoyed in 2015/16 will eventually soften, as higher inflation takes its toll on household real income growth. Uncertainties related to the UK's exit from the EU and important European elections are likely to weigh on investment. We doubt that moderately supportive fiscal policy and stronger exports will make up for weaker domestic demand – hence our projection of GDP growth slowing from 1.6% in 2016 to 1.3% in 2017 and 1.2% in 2018. But we acknowledge the upside risk from stronger exports.

ECB: no immediate implications, but data strengthen the case of the hawks

We do not think the strength of the sentiment data and the pick-up in inflation in December has immediate policy implications for the ECB, as the Bank has only recently determined the course of its monetary policy in 2017. Yet, the latest data are likely to make future discussions in the ECB Governing Council more lively, and strengthen the hands of the hawks. We expect the ECB to start tapering as of January 2018, with a decision due possibly as early as 7 September, or 14 December at the latest.

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