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The Eurozone is Fielding a Powerful Game of Catch-Up

The eurozone continues to emit positive signals that its recovery is broadening across geographies and sectors. Purchasing managers' indexes for May showed the eurozone leading the way of the four-largest economies in the developed world for the fourth successive month. The U.S. and Japan saw slower but still relatively robust expansions. Meanwhile, Eurostat raised its first-quarter GDP growth numbers for the eurozone to 0.6% (2.4% annualized) from 0.5%, suggesting that the region is growing well above its potential growth rate, which international organizations such as the OECD estimate at around 1%.


  • The eurozone economy is set to grow above potential in 2017 and 2018, firing on all cylinders, with the expansion in GDP looking more balanced across geographies and sectors.
  • Paradoxically, the eurozone's constant rises in economic growth projections are being met with simultaneous cuts in inflation forecasts, reflecting still considerable slack in labor markets amid weak global commodity prices.
  • We believe the European Central Bank will extend its QE program through 2018 but at a much slower pace. We believe the refinancing rate will stay unchanged until at least 2019 but see the possibility of a rise in the deposit facility rate in late 2018.

The economic outlook for the eurozone is looking more balanced geographically. Germany and Spain are still outperforming, but The Netherlands, Belgium, and more recently France and Portugal are also posting stronger growth numbers. What's heartening is that the spread between the fast- and slow-growing economies in the eurozone is set to narrow in the coming year and a half. Italy's performance remains somewhat more concerning, however, even though first-quarter GDP growth was revised upward to 0.4% from 0.2% initially. Inventories and consumption were the main contributors, but investment declined 0.8% in real terms and net foreign trade (exports minus imports) contributed negatively to GDP growth. Business and consumer sentiment surveys as well as PMI data all suggest that growth in Italy, while positive, will lag behind the eurozone average once again this year.

The outlook is also looking more balanced across sectors. The manufacturing and service sectors are now converging. Europe ranked among the top eight countries in May in the global manufacturing PMI rankings. Germany, Austria, and the Netherlands posted the fastest growth, followed by Ireland and Spain. A similarly strong picture came from the initial estimate for the eurozone's June manufacturing PMI index. Meanwhile the construction sector, which had been sapping growth for several years in a row, is now making a positive contribution in most countries.

All Cylinders Afire

Looking forward, our June forecast has the eurozone as a whole growing above potential in both 2017 and 2018 (see table 1 at the end of this report). Revisions to this quarter's forecast were generally on the upside from our previous release in March, mainly reflecting stronger historical first-quarter data compared with previous estimates. We expect all growth cylinders to fire simultaneously. In summary, our new forecast puts eurozone GDP growth at 2% in 2017, up from 1.6% in our March forecast, and 1.7% in 2018 (1.5%). On a country basis, the revisions concern Italy (1.2% instead of 0.9% for 2017, unchanged at 1% in 2018), Germany (2.0% and 1.7% from 1.6% and 1.5%, respectively), France (1.6% and 1.7% from 1.4% and 1.5%) and Spain (3.0% and 2.6% from 2.5% and 2.1%).

The recovery in world trade should benefit eurozone exporters despite a slightly stronger euro exchange rate. Investment prospects, on the other hand, remained quite uncertain until recently. We believe the combination of a more benign political outlook, now that the Dutch and French elections are out of the way, continued improvement in profit margins, and higher capacity utilization should underpin stronger growth in capital expenditures. Corporate profit margins have gradually improved overall in the eurozone since 2012, to 41% in late 2016 from 39.5% in early 2012. The improvement has been particularly visible in France, a country where corporate margins have always been lower as a percentage of GDP than in the rest of the union. Here the effects of fiscal measures implemented under the previous government to reduce employers' social contributions have lifted profit margins to 32% in the final quarter of 2016 from a low of 30% in the second quarter of 2014. Yet this recovery in corporate investment across the eurozone is likely to remain more modest than in previous cycles. Only three of the major economies--Germany, Spain, and France--had investment above their 2007 levels at the end of first-quarter 2017. For the eurozone as a whole real corporate investment was still almost 4.0% below its first-quarter 2007 level at the end of 2016.

Replacement needs will undoubtedly boost spending to counter capital stock depreciation. But despite favorable financing conditions, loan data suggest this is happening only slowly. Indeed the pace of expansion in credit to the nonfinancial corporate sector has remained rather lackluster.


Household spending will continue to support growth in the coming two years, in our view. Although we do not expect an acceleration in consumer demand, we do not see any major obstacles that would slow it down. The temporary spike in headline inflation bit into disposable income growth earlier this year, but continuous improvement in the labor markets is supporting consumer sentiment. The latter reached a 16-year high in June, according to the European Commission. Since its trough in second-quarter 2013, 5 million jobs have been added in the eurozone. The latest numbers for first-quarter 2017 showed employment up 0.4% on the quarter and 1.5% on a year earlier. In addition, we see little risk to household spending coming from higher savings ratios. After a temporary hike during the 2008-2009 global crisis (due to a surge in precautionary savings as a severe recession was looming), savings rates have come down very slowly. Spain is the only exception where consumers may want to increase their savings after several years of marked decline. But generally speaking, the very low prevailing interest rates in the union offer little incentive for households to arbitrage in favor of more savings and less spending.



No Surge In Inflation In Sight

It's becoming a habit: Since 2015 when the European Central Bank (ECB) published its first inflation forecast for 2017, every subsequent revision has been downward. Its most recent economic forecast in June was no exception. The projections contained a higher GDP growth forecast for 2017 at 1.9% from 1.8% (and 1.8% from 1.7% for 2018) but a lower estimate for inflation at 1.5%, falling short of the previous forecast of 1.7%. The downward revision for next year's inflation rate was even more substantial, with a rate of 1.3% now expected (versus 1.6% in the March release).

It is no small paradox to see constant rises in economic growth projections and simultaneous cuts in inflation forecasts. The opposite would look more normal. But it's precisely this paradox that illustrates that the eurozone economies are not yet back to "normal" but are instead still healing from the trauma of the Great Recession. Recent wage trends illustrate this situation. Higher economic growth has not yet translated into higher wage growth. Unit labor costs, which correspond to wages adjusted for productivity, have been growing at a low 0.8% to 1% year on year in the past four quarters. Hourly labor costs reflect similar trends, up about 1.5% in the past 12 months.

We noted earlier that labor market conditions across the union have been improving since 2015. Yet the pass-through to wages has been minimal so far. One possible explanation is that very low inflation expectations have dampened collective bargaining demands for pay increases. For sure, earlier this year, headline inflation spiked to 1.9% year on year in April (1.5% in March) while core inflation bounced more modestly to 1.2%. But this spike was mainly attributable to the sharp rise in oil prices in late 2016 and a weakening in the euro exchange rate against the U.S. dollar. Expressed in euros, Brent oil prices were up by as much as 107% year on year in February. Since then, the trend has reversed: oil prices fell and the euro appreciated. As a result, by mid-June oil prices denominated in euros fell 6% over 12 months. This retreat is unlikely to fuel expectations of higher headline inflation.

A second explanation for the lack of pass-through to wage increases is that the improvement in the labor market is partly misleading. Unlike in previous cycles, higher employment hasn't yet resulted in stronger bargaining power for wage earners and employees. That's because only a fraction of new jobs are actually full time, with a real long-term guarantee of continued employment. Looking across the eurozone, U6 rates suggest more slack in labor markets than the official jobless rates indicate. While Eurostat doesn't publish U6 rates, it publishes components that allowed us to build this useful indicator for the eurozone. It's a broader measure of labor market slack, which besides full unemployment includes underemployed part-time workers (working fewer hours than they would like), people seeking work but not immediately available (because they have received a job offer with a start date at some point in the future or because they are not able to start work within the next two weeks), and people eligible to work but not proactively seeking a job (discouraged workers). The contrast is sharp even in Germany where the U6 rate stood at 9.3% in December 2016, compared with a 3.9% unemployment rate. The French U6 rate was 18% in December versus a jobless rate of 9.9%; in Spain, the rates were 28.4% and 18.6%, respectively.


The amount of actual slack still present in the eurozone's labor market suggests that the pass-through from stronger economic growth to wages is likely to be very gradual, with compensation per employee rising from about 1.8% at the start of 2017 to about 2% in early 2018. Combined with still weak international commodity prices and a slightly stronger euro exchange rate than in 2016, this leads us to expect headline inflation to stay low in the next two years. Our forecast has eurozone inflation averaging 1.6% in 2017, 1.5% in 2018, and 1.7% in 2019.

The ECB's Patience Is Becoming Legendary

Despite the welcome acceleration in GDP growth, the lack of pickup in headline inflation across the European Monetary Union appears to justify the central bank's continued accommodative stance. The ECB has four criteria for assessing the inflation outlook in informing its monetary policy stance (tighter or looser):

  • First, headline inflation should be close to but below 2% in the medium term. On that measure the recent spike seems essentially driven by external factors (oil, exchange rate).
  • Second, the pickup should be durable, not transient. Core inflation has remained subdued so far.
  • Third, higher inflation should be self-sustained, but at present, as noted above, there is no visible sign of a wage-price loop shaping up.
  • Finally, the pick-up in inflation should be broadly visible across the union. At this point, we still see some significant dispersion among eurozone members.

These criteria suggest the ECB will still use caution when adjusting its overall monetary stance.

Based on its assessment of inflation prospects, the central bank has several sets of tools at its disposal to influence the steepness of the yield curve and overall credit conditions. Its first set includes the main refinancing operations rate, currently at 0%, and the deposit facility rate, at -0.40% since March 2016. The latter is typically used by central banks as a tool to influence the exchange rate. The ECB brought its deposit facility rate into negative territory in June 2014 (starting from -0.10%) to curb the strengthening of the euro effective rate. This policy worked well in 2015 and 2016, especially against the U.S. dollar. Our expectation at the end of last year was that the bank was likely to bring the deposit rate back toward zero in the final part of 2017. But we have now reconsidered this prediction: Over the first six months of this year, the U.S. dollar exchange rate dropped 7% against the euro. The euro remains well below its most recent peak in 2014 ($1.39 in March 2014 versus $1.13 over the first two weeks of June 2017), but the recent strengthening leads us to now expect no change in the ECB's deposit rate before the very end of 2018.

The second set of tools, often referred to as "nonstandard monetary policy measures" is more quantitative and includes TLTROs (targeted long-term refinancing operations) and the asset purchase program (or QE for quantitative easing). A first set of TLTROs was announced in June 2014 and a second series (TLTRO II) in March 2016. In March 2017 the ECB injected over €200 billion into the eurozone banking sector in its final TLTRO round with an interest rate of zero that could fall to -0.40%--depending on each bank's lending pattern. At the end of April 2017, Italian banks held just over €250 billion of the long-term loans--almost one-third of the total. Spanish banks had €173 billion, French banks €115 billion, and German banks €95 billion. TLTRO funding appears to have played less of a role in stimulating economic activity--we noted earlier that credit growth has only slowly picked up--but a larger part in alleviating the negative effects that very low interest rates are having on banks.

Nonstandard monetary policy measures also include the expanded asset purchase program. Monthly net purchases in the public and private sector are intended to be carried out until the end of 2017 and in any case "until the Governing Council sees a sustained adjustment in the path of inflation that is consistent with its aim of achieving inflation rates below, but close to, 2% over the medium term" (ECB statement). The program started in March 2015 with a monthly pace of €60 billion, a number that rose to €80 billion in April 2016. At the December 2016 meeting, the ECB made a number of important changes to the program. It scaled back the monthly pace to €60 billion. It also allowed purchases below the ECB's deposit rate of -0.40% and extended the universe of eligible maturities to 1-30 years from 2-30 years. The fine-tuning was aimed at addressing a potential scarcity issue that is contained in the very design of the program itself. Indeed the Public Sector Purchase Program spreads purchases across member states according to the ECB's capital keys. This has meant that the countries with the largest share (26.3% in the case of Germany) must receive the largest flows even though their net issuances may not be the largest. Hence a potential scarcity issue that could soon affect countries like Germany, most probably by the beginning of 2018.

What's Next? Lower for Longer

The ECB's balance sheet is now still expanding as fast as it was in early 2015 even though economic conditions have changed (and improved) since then. The challenge for the central bank is to avoid confusing markets with its forward guidance by maintaining a dovish bias despite positive economic data--or conversely, to prevent markets from expecting a fast tapering of QE, causing yields to spike. Our view is that the ECB's normalization sequence will extend through 2019, in line with a very slow improvement in inflation prospects, and will be symmetrical to its easing phase. In other words, the bank will all but end its QE program before it raises interest rates, leaving aside the possibility of a rise in the deposit facility rate in 2018 as explained above. We believe the ECB's scaling down of QE could be announced at the next September meeting and implemented from January of next year, with the monthly pace initially cut to €40 billion and then to €20 billion in the second half of the year. The ECB could also follow the Swedish example and maintain a more "occasional" presence in the market without officially ending in full its purchase program. GDP growth in Sweden reached 3.2% in 2016 and averaged 2.8% per year since 2009 (versus 1.1% a year in the eurozone). Inflation has steadily increased since 2015 to reach almost 2% in April 2017. Yet the Swedish central bank's QE program, which started in February 2015, is still alive. Its total size appears relatively modest compared with that of other central banks, at Swedish krona (SEK) 290 billion, or 7% of the country's GDP, compared with 17% for the ECB or 40% for the Bank of Japan. In its latest move, the central bank announced in April it was extending its program by a further SEK15 billion in the second half of the year. The amount itself looks very small, but that way the central bank tries to focus the market's attention on the stock of QE, which is still rising, rather than on the monthly flows, which are decreasing toward zero. This could prove an effective way for the ECB to manage market expectations and avoid risks of a sudden spike in long-term rates.

In any case, we see the ECB normalizing its monetary policy over a very long period of time as it brings its QE program (close to) zero by the end of 2018. However, we believe there could be further delays into 2019 if external conditions (commodity prices, exchange rate) become more deflationary.

Table 1: Main European Economic Indicators June 2017

Central Forecast
Real GDP Change
2015 1.5 1.0 0.7 3.2 2.0 1.5 1.9 2.2 0.8
2016 1.8 1.1 1.0 3.2 2.1 1.2 1.7 1.8 1.3
2017(f) 2.0 1.6 1.2 3.0 2.2 1.6 2.0 1.4 1.4
2018(f) 1.7 1.7 1.0 2.6 1.9 1.6 1.7 0.9 1.7
2019(f) 1.5 1.5 1.2 2.0 1.8 1.5 1.5 1.3 1.6
2020(f) 1.4 1.5 1.3 1.7 1.7 1.4 1.5 1.5 1.7
CPI Inflation (%)
2015 0.1 0.1 0.1 -0.6 0.2 0.6 0.0 0.1 -1.1
2016 0.4 0.3 0.0 -0.3 0.1 1.8 0.2 0.6 -0.4
2017(f) 1.9 1.1 1.5 2.3 1.5 2.4 1.6 2.7 0.3
2018(f) 1.8 1.4 1.3 1.3 1.6 1.6 1.5 2.3 0.5
2019(f) 2.1 1.4 1.7 2.1 1.9 1.8 1.7 1.8 0.9
2020(f) 2.2 1.6 1.9 1.7 2.1 1.9 1.8 1.9 1.2
Unemployment rate (%)
2015 4.6 10.4 11.9 22.1 6.9 8.5 10.9 5.4 3.3
2016 4.2 10.0 11.7 19.6 6.0 7.9 10.0 4.9 3.3
2017(f) 3.7 9.4 11.3 17.3 5.0 6.7 9.1 4.7 3.3
2018(f) 3.4 8.9 10.8 15.7 4.6 6.2 8.5 5.0 3.3
2019(f) 3.3 8.5 10.4 14.5 4.3 6.0 8.1 5.2 3.2
2020(f) 3.2 8.3 10.0 13.6 4.0 6.0 7.7 5.2 3.2
10-year bond yield (yearly average)
2015 0.5 0.8 1.7 1.7 0.7 0.9 1.2 1.9 -0.1
2016 0.1 0.5 1.5 1.4 0.3 0.5 0.9 1.3 -0.3
2017(f) 0.4 0.9 2.3 1.8 0.6 0.8 1.2 1.3 0.0
2018(f) 0.8 1.3 2.8 2.4 0.9 1.2 1.6 1.7 0.3
2019(f) 1.1 1.6 3.3 2.6 1.2 1.6 1.9 2.1 0.7
2020(f) 1.4 2.1 3.6 2.9 1.6 1.9 2.3 2.5 0.9
Central banks policy rates (yearly average) Eurozone (ECB) U.K. (BoE) Switzerland (SNB)
2015 0.05 0.50 -0.73
2016 0.01 0.40 -0.75
2017(f) 0.00 0.25 -0.75
2018(f) 0.0 0.25 -0.75
2019(f) 0.20 0.34 -0.56
2020(f) 0.45 0.81 -0.31
Exchange rates Eurozone U.K. Switzerland
2015 0.05 0.50 -0.73
2016 0.01 0.40 -0.75
2017(f) 0.00 0.25 -0.75
2018(f) 0.00 0.25 -0.75
2019(f) 0.20 0.34 -0.56
2020(f) 0.45 0.81 -0.31

Source: Aon Securities Inc. N.A.-Not available.

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