European Growth Outlook 10/2018

October 2018 EUROPEAN GROWTH OUTLOOK

Euphoria turns to disillusionment Europe’s economy passed its cyclical peak



The BDI is expecting the EU economy to grow by slightly over two percent this year. Following growth of 2.4 percent last year, the economy has passed its peak. Private consumption and investment remain the primary drivers of growth.



The trade disputes are now reflected in the hard figures. The contribution of net exports to GDP growth has been decreasing for several quarters.

In the second quarter it turned negative, reaching minus 0.3 percent, half a percentage point lower than in the preceding quarters.



Brexit is looming large. The United Kingdom grew by only 1.1 percent in the first six months of the year compared to the same period last year, performing second to last among the EU28. The European Commission is expecting the weakest growth in the United Kingdom and Italy next year, forecasting 1.2 percent in both cases.



Europe is entering a slowdown in its economic cycle. Growing nationalism and protectionism are also curbing growth by hampering foreign trade.

Domestic demand remains strong but may well come under pressure from second-round effects. Export-oriented countries with a strong industrial sector, like Germany, will be affected most.



The unemployment rate of 6.8 percent in the EU has dropped below pre-crisis levels for the first time. Unemployment in the euro area is slightly higher at 8.1 percent. The shortage of skilled workers is coming to a head. Inflation is close to the target rate of below, but close to, two percent.

Monetary policy is slowly returning to normal.



The European Parliament elections will be a watershed moment: a choice between a sovereign Europe and weak nation states.

Euphoria turns to disillusionment | Europe’s economy passed its cyclical peak 18/10/2018

Content European policy more relevant than ever for German industry ..................................................... 3 European Parliament elections will be a watershed moment ............................................................... 3 Moderate economic expansion continues in Europe ...................................................................... 3 Private consumption and investment still gathering pace with exports slowing down .......................... 4 Narrower range of growth rates ............................................................................................................ 4 Global economy still developing according to plan ............................................................................... 5 Industrial activity has passed its peak .............................................................................................. 6 Unemployment rate decreasing steadily and approaching pre-crisis levels ......................................... 7 Exchange rates remain volatile ............................................................................................................. 8 Inflation approaching target value of below, but close to, two percent ........................................ 9 Monetary policy gradually less expansionary...................................................................................... 10 Lending getting back to normal ........................................................................................................... 11 Political events unsettle European markets ........................................................................................ 12 Conclusions for European and German industry .......................................................................... 13 Sources .............................................................................................................................................. 14 Imprint ................................................................................................................................................ 15

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Euphoria turns to disillusionment | Europe’s economy passed its cyclical peak 18/10/2018

European policy more relevant than ever for German industry The election of Emmanuel Macron in 2017 to the French presidency seemed to give new momentum to the process of European integration. The young Macron managed to beat populist Marine le Pen to join the heads of state and government with a clear commitment to the EU. The president swiftly presented a detailed concept for reforms to stabilise the economic architecture of the EU. Even ten years after the financial crisis, reforms are still badly needed, particularly as Europe reached its cyclical peak in 2017. It is only a matter of time before Europe slips into the next recession. However, we are mostly seeing standstill and uncertainty on the political level. After Germany finally managed to form a federal government, Italy shocked the EU with the election of two populist parties. The current budget debate reveals just how risky this Italian coalition is. Furthermore, a hard Brexit is looking ever more likely. Although the Chequers’ plan recently presented by the UK government is its first coherent exit proposal, it does not seem acceptable to the EU27. At the same time, the export-oriented European economy is increasingly feeling the brunt of US trade policy. At first glance, the European economy appears to be braving the storm well with some indicators still in positive territory – growth continues at a moderate pace, unemployment is reaching pre-crisis levels, inflation is approaching the target rate of two percent and a weaker euro could boost foreign trade. Nonetheless, some international institutions have downwardly revised their growth forecasts. The stock markets and business climate indices are being affected by the political uncertainties and a turnaround in monetary policy is on the horizon.

European Parliament elections will be a watershed moment Industry needs the EU to prepare itself more rigorously for the challenges ahead (see also the statement from industry “A Strong and Sovereign EU”, BDI 2018). A stronger European economic and monetary union is the only way that Europe will be able to mitigate future crises (Deutsch 2018b). Internal consolidation within the EU is key to maintaining a positive business climate. The highly export-oriented German industry, in particular, depends on a solid, predictable global environment. The EU must take a resolute and united stand in support of a multilateral and rule-based world order. The European Parliament elections in May 2019 will be a watershed moment for trade and industry. The outcome will decide whether the EU continues as a strong and united Europe or becomes a weak group of nation states.

Moderate economic expansion continues in Europe The European economy continued to expand moderately in the first six months of 2018, albeit at a slower pace than the previous year. In the second quarter 2018, GDP increased by 0.4 percent over the previous quarter after seasonal adjustment in both the EU and the euro area thus maintaining the pace of growth recorded in the first quarter. Following growth of 0.6 and 0.7 percent in all four quarters of 2017, this shows that economic growth in Europe has definitely slowed down. France, Italy and Greece have been particularly disappointing, with GDP growth at a low 0.2 percent in all cases. With 0.4 percent, the United Kingdom has grown slightly more than at the start of the year. Germany, with a 0.5 percent increase in GDP, is continuing to grow solidly above its potential growth rate. Strong growth was recorded particularly by the Central and Eastern European countries.

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Euphoria turns to disillusionment | Europe’s economy passed its cyclical peak 18/10/2018

Growth in real GDP in the EU in percent 3

2

2.4

2.3

2.1 1.7

2.1 (P)

2.0

1.8

1 0.3 0 -0.4 -1 I

II III IV I

II III IV I

II III IV I

II III IV I

II III IV I

II III IV I

II III IV I

II III IV I

II III IV

2010

2011

2012

2013

2014

2015

2016

2017

2018

change over previous year quarter

change over previous quarter

change over previous year

Source: Macrobond

Private consumption and investment still gathering pace with exports slowing down Domestic demand was by far the primary driver of growth in the second quarter. Consumption expenditure of private households increased by 0.3 percent in the EU and 0.2 percent in the euro area (following 0.5 percent in the previous quarter).

Private consumption has slowed a little but consumer confidence remains at an all-time high due to the positive trend on the labour market and a moderate increase in wages. State consumption expenditure, up 0.4 percent, grew slightly more than at the start of the year. Gross fixed capital formation showed a favourable development, going up by a vigorous 1.2 percent both in the EU and in the euro area (after 0.3 percent in the first quarter).

Foreign trade, which had contributed solidly to growth in 2017, is currently curbing GDP growth as exports are increasing at a slower rate than imports. In sum, net exports contributed minus 0.2 percentage points to GDP growth in the second quarter. Net exports have been decreasing steadily for around one year now, with the trade disputes now having a clear impact on exports.

Narrower range of growth rates The United Kingdom, Italy and France will grow at below average rates this year. The European Commission is expecting the United Kingdom and Italy to show the lowest growth in the EU in 2019, at only 1.2 percent. Brexit is the reason for the low growth expectations for the UK, while in Italy declining exports and weaker private consumption are making the economy stall. At the same time, political uncertainty is weighing down on the business climate. Overall in the EU, the spectrum of growth rates is decreasing. In 2018, growth rates will be between 1.2 and 5.8 percent and they are expected to lie between 1.2 and 5.2 percent in 2019.

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Euphoria turns to disillusionment | Europe’s economy passed its cyclical peak 18/10/2018

Range of growth rates* in the EU 12 Highest

8

Average

4 0 Lowest -4 -8 -12 -16 2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

2019

*Range of growth in real GDP in the EU (highest, lowest and average growth rate in the EU), Ireland not included on account of statistical outliers.

Sources: Macrobond, AMECO

Despite the many political uncertainties and risks, the macroeconomic environment for the EU and the euro area remains robust overall and we should continue to see moderate economic growth. This is also reflected in the forecasts of both European and international institutions. In its summer forecast, the European Commission (2018) predicted 2.1 percent growth in GDP for 2018 (down 0.2 percentage points compared to its May forecast) and two percent in 2019 for both the EU overall and the euro area. In September, the ECB (2018) forecast two percent growth for the euro area in 2018 and 1.8 percent in 2019, while the OECD’s (2018) September forecast predicted growth rates of two percent for 2018 and 1.9 percent for 2019 in the euro area. The IMF (2018) in July forecasts 2.2 percent for 2018 and 1.9 percent for 2019. Europe thus seems to have reached its cyclical peak in 2017, with vigorous growth rates of 2.4 percent in the EU and the euro area. The summer forecast of the European Commission (2018) anticipates above-average growth among the major economies particularly in Poland, the Netherlands and Spain for both 2018 and 2019. Germany is expected to grow at the average EU growth rate in 2018 and slightly above it in 2019.

Global economy still developing according to plan Despite the geopolitical instabilities and increasing trade disputes, the global economy is still in good shape overall. Following a relatively weak first quarter, with 0.9 percent growth over the previous quarter, the second quarter showed slightly higher momentum at just over one percent growth over the previous quarter. Economic growth in the euro area and the US, in particular, was robust and should continue to expand, albeit at a slightly slower pace. Private consumption will continue to be the main driver of growth, buoyed by a steadily improving labour market and moderate price and wage increases.

However, the risks for economic growth going forward have increased substantially. The international economic institutions, especially the OECD and the IMF, have explicitly warned of these risks and have

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Euphoria turns to disillusionment | Europe’s economy passed its cyclical peak 18/10/2018

factored them into their forecasts (Deutsch 2018a). The uncertainty created by US trade policy is making companies nervous and affecting their investment decisions and foreign trade activities. The growth of the global economy is being shouldered by ever fewer national economies.

The IMF (2018, July forecast) is expecting the global economy to increase by 3.9 percent in 2018/2019, the OECD (2018, September forecast) is forecasting 3.7 percent for 2018/2019. We expect real growth of a good four percent for 2018 overall. The industrialised countries will grow robustly with around 2.5 percent growth, while the developing and emerging countries should grow by around five percent (Deutsch 2018a). With many indicators weakening, economic momentum is likely to lose steam by around a quarter of a percentage point next year.

Industrial activity has passed its peak The latest figures for industrial production are dampening economic sentiment. In July, industrial production fell noticeably by 0.7 percent in the EU and 0.8 percent in the euro area compared to June.

The drop was caused mainly by a reduced production of consumer goods (down 1.3 percent), consumer durables (down one percent) and intermediates (down 0.6 percent). In contrast, the production of energy (up 0.7 percent) and capital goods (up 0.6 percent) increased. Production figures for June were already disappointing, with drops in all main groups and in many EU states.

The purchasing managers’ index, at 54.5 points in August, is still signalising growth but was down 0.2 points on the previous month. Sentiment is much less optimistic than at the turn of the year 2017/2018. The multiple political risks and uncertainties are pressing down substantially on business prospects, which in August recorded the lowest level in 21 months.

Industrial activity* in the Euro area 120

50 40

115

30 20

110

10 0

105

-10 -20

100

-30 95

-40 2011

2012

Production*

2013

Investment*

2014

2015

Purchasing Managers Index*

2016

2017

2018

ifo Economic Climate (right axis)

*Index: Q1/2014 = 100 Source: Macrobond

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Euphoria turns to disillusionment | Europe’s economy passed its cyclical peak 18/10/2018

Unemployment rate decreasing steadily and approaching pre-crisis levels Despite the systematic decrease in unemployment across Europe, some countries are still facing stubbornly high rates of unemployment. In the second quarter 2018, the unemployment rate dropped to 8.3 percent in the euro area, its lowest level since 2008. At 6.8 percent, unemployment in the EU was also at its lowest level since April 2008.

Unemployment rate in percent 13

27

11

22

9 17 7 12

5 3

7

EU 28

Euro area

Germany

France

Italy

Netherlands

U. Kingdom

Spain (right axis)

Source: Macrobond

Among the individual member states, the countries with the lowest unemployment in August were the Czech Republic (2.5 percent), Germany and Poland (both 3.4 percent). The highest level of unemployment was again recorded by Greece (19.1 percent in June, the most recent figures available) and Spain (15.2 percent in August). Even though unemployment is decreasing steadily in these countries, the labour market situation remains difficult. A big problem here is structural unemployment, which is difficult to cut even in times of economic growth. At the same time, almost all countries are facing a shortage of skilled labour in certain sectors.

On a positive note, the countries with the highest unemployment, Cyprus, Greece, Portugal and Croatia, also recorded the highest drops in unemployment compared to the previous year. This positive trend may come to a halt in Greece, however, if the implemented labour market reforms are reversed.

For 2018 overall, the ECB is expecting an unemployment rate of 8.3 percent (2018, September forecast). The ECB is forecasting a clear decrease in unemployment in the next few years, down to 7.4 percent in 2020. Unemployment is thus steadily approaching pre-crisis levels.

Youth unemployment (under 25-year-olds) has decreased substantially compared to the previous year.

In August 2018, youth unemployment in the euro area was at 16.6 percent compared to 18.5 percent in August 2017. Germany, Malta and the Czech Republic had the lowest youth unemployment at under seven percent in all cases, while it remains the highest in Greece (39.1 percent in June 2018), Spain (33.6 percent) and Italy (31.0 percent).

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Euphoria turns to disillusionment | Europe’s economy passed its cyclical peak 18/10/2018

Progress in fiscal consolidation, but some states still problematic In 2017, the government deficit in the EU dropped from 1.6 percent in 2016 to one percent. In the euro area, it decreased from 1.5 percent to 0.9 percent. Twelve EU member states, including Germany and the Netherlands, registered surpluses. Slovenia achieved a balanced budget, while 13 member states recorded deficits, although all remained under the three percent threshold. Spain and Portugal were the only countries whose deficit exceeded the threshold value.

Public debt as a percentage of GDP 2

2

0

0

-2

-2

-4

-4

-6

-6

-8

-8

-10

-10

-12

-12 2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

EU 28

Euro area

Germany

France

Italy

Netherlands

U. Kingdom

Spain

2017

Source: Macrobond

In its September forecast, the ECB (2018) sees budget deficits decreasing further until 2020. For 2018, it is expecting an overall deficit of 0.6 percent, followed by 0.8 percent in 2019 and minus 0.5 percent in 2020. These forecasts are based on continued improvements in the economy and on lower interest payments due to lower interest rates successively replacing the older, higher rates. It remains to be seen how the deficits will develop in the next few years in the individual member states. The budget plans of the Italian government are firming up. Interior minister Salvini and social minister Di Maio seem to have won out against the independent finance minister Tria. The new government has proposed a target deficit of 2.4 percent of GDP for 2019, in defiance of the 1.6 percent advocated by Tria. The final budget will be presented by the end of the year. French President Macron has also announced an extensive tax reform. France has recently slightly watered down its consolidation efforts.

Exchange rates remain volatile On the currency markets, the performance of the euro was mixed from March 2018 onwards, depreciating against the dollar in particular. The euro started losing ground against the dollar as early as the middle of April, fuelled by improved economic prospects and interest rate hikes in the US. Uncertainty surrounding the government formation in Italy in May also played into the equation. Since the start of the year the euro has, with some fluctuations, lost around four percent against the dollar.

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Euphoria turns to disillusionment | Europe’s economy passed its cyclical peak 18/10/2018

Nominal exchange rates, respective foreign currency per euro* 180

106

170

104

160 102

150 140

100

130

98

120

96

110 94

100 90

92

Turkish lira (left axis) Pound Sterling US dollar Yen Renminbi Nominal, effective exchange rate against the world’s twelve main currencies *increase means an appreciation of the euro against the respective currency Source: Macrobond, 1.1.2018 = 100

The euro trended similarly against the yen. Improved prospects after the weak economic figures and political uncertainties in spring only triggered a brief appreciation of the euro before unexpectedly good figures from Japan brought it back down. Compared to the start of the year, the single currency has lost around three percent against the yen.

Meanwhile the euro remained stable against the pound sterling with only minor fluctuations. The euro appreciated two percent against the renminbi. The trade tensions with the US are now making themselves felt on the country’s currency.

The Turkish lira recorded enormous gains against the euro, amounting in total to over 50 percent as figures stand. Even though the country has implemented numerous monetary measures, the markets question the independence of Turkey’s central bank. Sanctions from the US have compounded the situation.

Inflation approaching target value of below, but close to, two percent In August 2018, inflation in the euro area was at two percent, mainly due to increased energy prices.

According to preliminary Eurostat estimates, inflation in September was 2.1 percent. In its September forecast, the ECB (2018) is expecting prices to rise in 2018 overall by 1.7 percent compared to 2017, fuelled above all by increasing food and energy prices. Core inflation (without energy and foods) is expected to be 1.1 percent.

Until 2020, the ECB forecasts annual inflation of 1.7 percent. The increase in prices would then be close to, but still below, the target value of two percent. Increased labour unit costs will become the main driver of inflation, taking over from food and energy prices. The improved situation on the labour

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Euphoria turns to disillusionment | Europe’s economy passed its cyclical peak 18/10/2018

market will lift wages. The resulting increased labour unit costs will push prices up, at least in part (ECB 2018).

Range of inflation rates in the euro area 5

5 Maximum

4

4

3

3 80%-Percentile

2

2 Average

1

1 20%-Percentile

0

0 Minimum

-1

-2

-1

-2

-3

-3 2013

2014

2015

2016

2017

2018

Source: Macrobond

Monetary policy gradually less expansionary The ECB Council decided on 13 September 2018 to keep base interest rates at their current level until summer 2019 at least, or, in any case, as long as necessary to ensure that inflation approaches the two percent target. The ECB’s interest rate on the main refinancing operations remains at zero percent, the marginal lending rate at 0.25 percent and the deposit rate at minus 0.4 percent.

The ECB’s asset purchase programme continued until September 2018 with a volume of 30 billion euros per month. Starting in October, the volume is reduced to 15 billion euros a month. Plans are for net purchases to end after December if inflation prospects are pointing the right way. Maturing debt will be reinvested, however, to maintain favourable liquidity conditions and scope for extensive monetary policy adjustment. The phase-out of expansionary monetary policy is thus being cautiously continued.

An end to expansionary monetary policy could pose a potential risk for public budgets. High debt levels, slow growth and increased interest rates can be a volatile mix. The situation could be particularly precarious for Italy due to the political uncertainties that are impacting on its bond yields. The budget plans of the government need careful monitoring (see also Gros 2018). The latest proposal with a deficit of

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Euphoria turns to disillusionment | Europe’s economy passed its cyclical peak 18/10/2018

2.4 percent has done little to appease the financial markets and the spreads on Italian government bonds have continued to increase (see also Deutsche Bank Research 2018).

Key interest rates in selected countries 7 6 5 4 3 2 1 0

European Central Bank

Federal Reserve Bank

Bank of England

Source: Macrobond

The Federal Reserve Bank (FED) already initiated a turnaround in interest rates in late 2016 and has implemented five hikes since then, each of 0.25 percentage points. On 26 September, it raised interest rates for the third time in 2018 (again by 0.25 percentage points) in response to anticipated economic growth of over three percent. On the back of this forecast, the FED also signalised another hike in 2018 and three further hikes in 2019. This would take the base rate to over three percent by the end of 2019.

The yields for two-year US government bonds have reached their highest level in more than ten years, at just over three percent. This has triggered capital flows, in particular away from emerging countries.

The Bank of England raised interest rates by 25 base points to 0.75 percent in early August on account of increased inflation and slightly improved economic figures.

Lending getting back to normal According to the Bank Lending Survey of the ECB, the credit standards for non-financial companies continued to decrease in the second quarter of 2018, as it had in the previous quarter. The credit standards for large companies dropped slightly more than for small and medium-sized enterprises.

Among the large euro area economies, this was the case in Spain, Italy and Germany, while they remained the same in France and the Netherlands. The banks stated competitive pressure and reduced risk perceptions regarding the economic situation as a reason for the lowered standards.

Banks are expecting credit standards to ease up further in the third quarter 2018. The company survey of development bank KfW and the BDI of over 2,200 companies of all sizes showed a positive picture.

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Euphoria turns to disillusionment | Europe’s economy passed its cyclical peak 18/10/2018

Difficulties in accessing credit have decreased by 2.6 percent compared to the previous year and, at 12.5 percent, are at their lowest level since 2012 (KfW 2018).

Growth in credit and money supply in the euro area compared to the same month the previous year in percent 20

15

10

5

0

-5

-10

Amount of credit

Money supply M3

Source: Macrobond

Political events unsettle European markets After the strong recovery in July 2018, there were divergent trends on the stock markets in early August.

US stock markets were the top performers, boosted predominantly by abundant corporate profits and buoyant economic indicators, which are all still pointing to further strong growth following GDP growth in the second quarter of 4.2 percent year on year.

European stock markets, in contrast, took a downturn. The DAX 30 has lost around six percent since its interim high in early 2018. The Eurostoxx 50 trended similarly, dropping around five percent this year so far. London’s FTSE 100 also lost around five percent.

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Euphoria turns to disillusionment | Europe’s economy passed its cyclical peak 18/10/2018

Stock indexes

Euro area

Germany

U. Kingdom

Oct 18

Sep 18

Aug 18'

Jul 18

Jun 18

95

May 18

95

Apr 18

100

Mar 18

100

Feb 18

105

Jan 18

105

Dec 17

110

Nov 17

110

Oct 17

115

Sep 17

115

Aug 17

120

Jul 17

120

Jun 17

125

May 17

125

Apr 17

130

Mar 17

130

Feb 17

135

Jan 17

135

USA

Source: Macrobond, 1.1.2017 = 100

The downward trend in the euro area is a reflection of the concerns of the financial sector that the Turkish crisis could spread, about the trade disputes caused by the US and uncertainty regarding the political situation in Italy. On the one hand, the macroeconomic climate has shown a healthy development while, on the other hand, political events have caused uncertainty and swings on the financial markets. These uncertainties are not going to disappear any time soon, since they include the trade dispute between China and the US, the impending (hard) Brexit, budget decisions in Italy in September and Congress elections in the US coming up in November.

Conclusions for European and German industry Europe is in a cyclical downturn. Rising nationalism and protectionism are curtailing foreign trade which, in turn, is curbing growth. Domestic demand remains strong although it is starting to strain under second-round effects. Highly industrial, export-oriented countries such as Germany are particularly hard hit. A downturn in global trade is the largest risk facing industry.

The European Parliament elections in May 2019, at the latest, will be a watershed moment for or against a strong and sovereign EU. European industry would be well advised to support and work towards deeper European integration, multilateralism and an open world trade order. Companies need to engage more vigorously in the public debate to advocate openness and international collaboration.

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Euphoria turns to disillusionment | Europe’s economy passed its cyclical peak 18/10/2018

Sources BDI (2018). A Strong and Sovereign EU. Calling for Europe to Take on a New Role in the World.

Berlin/Brussels.

Deutsch, Klaus et al. (2018a). Global Growth Outlook September 2018. The Trump Risk. Trade and currency disputes threaten world economic growth BDI. Berlin.

Deutsch, Klaus (2018b). Strengthening EMU. Key points to strengthen the European Economic and Monetary Union. BDI. Berlin.

Deutsche Bank Research (2018). Italy: A deficit target to test tolerance. Focus Europe. 28. Frankfurt/M. European Commission (2018). Summer 2018 Interim Economic Forecast. Brussels.

European Central Bank (2018). Staff macroeconomic projections for the euro area. September.

Frankfurt/M. Gros, Daniel (2018). Financial Stability Implications of Increasing Interest Rates. CEPS Policy Insights No. 2018/10. Brussels.

IMF (2018). World Economic Outlook Update, July. Washington D.C..

KfW (2018). Unternehmensbefragung: Stimmung auf dem Kreditmarkt ungebrochen gut. Frankfurt/M. OECD (2018). Interim Economic Outlook. 20 September 2018. Paris.

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Euphoria turns to disillusionment | Europe’s economy passed its cyclical peak 18/10/2018

Imprint Bundesverband der Deutschen Industrie e.V. (BDI) Breite Straße 29 10178 Berlin T: +49 30 2028-0 www.bdi.eu Authors Dr. Wolfgang Eichert T: +3227921014 w.eichert@bdi.eu Solveigh Jäger T: +49 30 20281533 s.jaeger@bdi.eu Karl Thies BDI/BDA Business Representation

Editorial/Graphics Dr. Klaus Günter Deutsch T: +49 30 2028-1591 k.deutsch@bdi.eu Marta Gancarek T: +49 30 2028-1588 m.gancarek@bdi.eu

This European Growth Outlook is a translation based on „Wachstumsausblick Europa“ as of 9 October 2018.

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