Dont panic about Euro zone growth yet

Eurozone GDP growth in Q4 declined to 0.9% year-on-year and only 0.1% over Q3. Q1 looks set to be weak too, but mainly because of the impact of the coronavirus. There is an underlying upturn in the industrial sector, which was evident in some of the leading indicators in recent months. That may be on hold now for a few weeks but the economy generally is not unhealthy. Unemployment at 7.4% is essentially back to 2008 levels (7.3%) and GDP growth at about 1% is close to trend. The ECB’s concern is that inflation is below its 2% target (at about 1%). Hence the resumption of monetary easing in 2018.

The threat from the coronavirus

At present the global effects of the coronavirus are on a cusp. We should know in the next 2-4 weeks whether it will follow a mild infection trajectory and soon peak, or whether it will ‘break out’ from China in a significant way, keeping people indoors (not just in China) and damaging the world economy more significantly. At present rising stock markets suggest investors are betting that the break-out is not going to happen. Lets hope they are right.

But even the impact we are seeing already in China will affect the euro zone by reducing new orders from China, bringing shortages in parts for companies that rely on imports from China and reducing Chinese tourism. Germany is worst affected by this because of its reliance on manufacturing and the importance of its exports to China. However, either way, the economic effects of the coronavirus should be temporary with a bounce back and recovery in Q2 or maybe Q3.

A healthy economy

The underlying euro zone economy looks healthy in most respects, despite fears over the slowdown. Investment is expanding strongly, consumer spending is growing at a healthy pace, the stock market is up and inflation is low. The slowdown in GDP growth is mainly attributable to weaker exports, combined with strong imports linked to the investment boom and an inventory correction. The prevailing mood of pessimism about the cyclical situation reflects mainly Germany’s position, close to recession. Taken as a whole, however, the Euro zone is in a reasonably healthy position.

Leading indicators started to turn round at the end of 2019 led by sentiment indicators. Fiscal policy is still mildly contractionary (though Germany may switch to a slightly more expansionary stance this year), but monetary policy is very loose. The turnaround will mainly reflect the end of the inventory correction and perhaps a modest pick-up in foreign demand, once the coronavirus is past. I expect the ECB to keep rates on hold but an expansion of bond purchases is possible.

Long-term concerns over the euro remain

Concerns over the future of the euro have virtually disappeared from the markets at present with yield spreads narrow and Greek 10 year government yields below 1%. The UK's tortuous Brexit story has made continental nationalists back away from leaving the euro. If it is so difficult to leave the EU it must be impossibly difficult to leave the euro as well! Still, in the event of a new recession, the euro will likely be tested once more. The institutions necessary to support the euro in the long run have still not been created – banking union, a single zero-risk euro security and greater fiscal sharing. It is a reasonable bet that governments will make the necessary changes when they absolutely have to, next time the euro comes under existential pressure. But this will be contingent on the political situation and there are no guarantees. In particular, if it is Italy in trouble next time, rather than tiny Greece, the situation will be much more difficult.