European growth to remain good, albeit slower

Year Ahead 2018 regional outlook: Europe

 

29 November 2017

This article is part of the UBS House View Year Ahead 2018, our yearly outlook on markets. You will find investment ideas and portfolio implications in the full report.

While European growth could slow relative to 2017 due to a stronger euro and regional risks such as the end of European Central Bank (ECB) easing, Brexit process and political uncertainty in Italy and Spain, we remain positive on Europe in general. The economic backdrop of the Eurozone remains robust and supports stronger government finances and tighter integration.
 
In the short term, the Eurozone will likely face some economic headwinds. The OECD leading indicator for the region appears to be topping out, and the stronger euro has tempered export orders. Still, we expect only a moderate slowdown thanks to strength in other areas of the economy. The labor market continues to heal and should reach full employment toward the end of the coming year. The housing cycle has turned positive and has further room to run: construction spending remains below the excesses of the 2000s, and home prices are still only moderately higher than in the last peak in 2007, though the nominal size of the economy has expanded significantly since then. We expect domestic demand to hold up relatively well.

For the first time since 1999, when the euro was introduced, every Eurozone member state is expected to comply with the Maastricht deficit criterion – i.e. a government deficit not exceeding 3% of GDP. In addition, the aggregate deficit is estimated to reach only 1% of GDP, below the deficits of the US, Japan, and the UK. Accordingly, each member state’s debt-to-GDP ratio should also either stabilize or fall for the first time since 1999. Even Greece is set to leave its bailout program in the summer.
 
With a business-friendly French government, almost all European-level presidencies up for appointment in 2018 and 2019, and public support for the EU and the euro at historical highs, the region has a major opportunity to speed up integration in the year (and years) ahead. And even in the unlikely event that the so-called Jamaica talks break down in Germany, an unexpected grand coalition might even speed up the integration process. Greater Eurozone integration should ultimately enhance the euro’s resilience to further shocks.

Brexit negotiations: It ain’t over till it’s over

Brexit negotiations are scheduled to end in September, and their failure would constitute an asymmetric shock to the Eurozone, as different countries have different exposure to the UK. Even if the talks succeed, the ratification process will likely take six months, which entails risks of its own. For example, ratification of the EU-Canadian free trade agreement almost failed because Wallonia, a region in Belgium, opposed it. A failure of discussions may increase deflationary risks, forcing the ECB to extend quantitative easing beyond September and postpone the expected start of its rate hike cycle in 2019.
 
That said, given the EU’s hard stance with the UK, ratification looks probable, and should Brexit still fail, businesses and households would have until March 2019 to adjust. So we estimate that a hard Brexit, coupled with the corresponding ECB response, would pare half a percentage point off the Eurozone’s potential GDP growth in 2019.
 
Beyond Brexit, political risk lies in Italy and Spain. In the Italian elections, even if the threat of a euro referendum has receded and the recent reform of the electoral law favors broad centrist coalitions, there is the danger of an inconclusive vote leading to another technocratic government or repeat elections. This may prolong business and household uncertainty and heighten the risk of a fragmented government. Spain, meanwhile, is facing a secessionist challenge in Catalonia, which has already moderately hampered local economic growth.

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