Eurozone real GDP growth decelerates expectedly to 0.3% q/q in Q2

A new "preliminary flash reading" from Eurostat shows that Eurozone GDP growth matched IHS Markit's expectations in the second quarter of 2016 as it halved to 0.3% quarter on quarter (q/q) from 0.6% q/q in first quarter, which was the equal best q/q growth rate (with the first quarter of 2015) since the first quarter of 2011. This was preceded by Eurozone GDP growth losing momentum in the second half of 2015, following expansion of 0.4% q/q in the second quarter and 0.6% q/q in the first quarter. Year-on-year Eurozone growth slowed slightly to 1.6% in the second quarter of 2016 from 1.7% in the previous two quarters.

The slowdown in Eurozone GDP growth in the second quarter of 2016 appeared to suggest that activity took a bigger hit from increased global and domestic economic uncertainties, as well as financial-market volatility and weakness early on in the year. In addition, softer growth in the second quarter was also partly influenced by first-quarter expansion benefiting from the mild weather boosting construction activity. Although Eurozone economic sentiment remains at a supportive level, the increased uncertainties prior to the United Kingdom's vote on its European Union membership had some unsettling effects on confidence in some Eurozone countries during June. Specifically, the European Commission's overall economic sentiment indicator has edged back to 104.4 in June, after rising to 104.6 in May, from 104.0 in April, and 103.0 in March.

Consumer spending and investment likely to have lost dynamism in the second quarter

There is no breakdown yet of Eurozone GDP growth in the second quarter, but weaker growth appeared to be partly triggered by some loss of momentum in consumer spending and business investment in the region. In addition, evidence from France was a loss of momentum in both industrial and construction investment. French GDP growth in the second quarter was derailed by consumer spending stagnating after rising 1.2% q/q in the first quarter (this was partly a correction after consumer spending was hit in the fourth quarter of 2015 by the November terrorist attacks in Paris).

Net trade probably had no effect on Eurozone GDP growth in the first and second quarters, after being a significant drag on activity from mid-2015 (knocking 0.3 percentage point off q/q Eurozone growth in the first quarter). Net trade added 0.3 percentage point off French GDP growth in the second quarter of 2016, as opposed to a 0.4-percentage-point negative drag in the first quarter of 2016.

Softer second-quarter growth was partly due to a loss of momentum in France

Eurozone GDP growth in the second quarter was partly affected by French growth stalling after expanding by 0.7% q/q in the first quarter, which had represented bounce back from the hit to economic activity (particularly consumer spending and services activity) from the November Paris terrorist attacks. Additionally, Austrian GDP growth slowed slightly to 0.3% q/q in the second quarter of 2016 from 0.4% q/q in the first quarter. Furthermore, Spanish GDP growth also lost slight momentum to stand 0.7% q/q in the second quarter of 2016, just below the 0.8% q/q gain in the previous three quarters.

IHS Markit suspects that second-quarter Eurozone GDP growth also slowed as a result of a weaker expansion in Germany in the second quarter, while we also expect there to have been a modest growth performance in Italy. Specifically, we expect German GDP growth to have decreased to 0.4% q/q in the second quarter from 0.7% q/q in the first. Both the Bundesbank and the finance ministry have indicated that German growth will slow in the second quarter. According to the finance ministry, "economic indicators overall suggest a continuation of the economic upswing, albeit at a less dynamic pace than at the beginning of the year." Additionally, we expect Italian GDP growth edged down to 0.2% q/q in the second quarter from 0.3% q/q in the first quarter of 2016.

Outlook and implications

The loss of momentum on Eurozone growth in the second quarter was expected, and signals more challenging growth developments in the next few quarters. We expect a step-down in the quarterly growth for the region in the next three quarters, probably to around 0.2% q/q. The Brexit vote has put a major dent into Eurozone growth prospects. Our projections were revised down markedly in our July forecast. Specifically, we now see Eurozone GDP growth coming in at 1.5% (from 1.7%) in 2016, then moderating to 1.1% (from 1.8%) in 2017. Growth in 2018 is seen improving to 1.5%, although this is also concluded in uncertainty and much could depend on how negotiations between the UK and the EU pan out.

IHS Markit suspects that the UK vote to leave the EU is likely to hurt the Eurozone through a number of channels. Specifically, we see the UK decision and the leaving process triggering markedly increased political turmoil across Europe, weighing down on business and consumer confidence across the Eurozone, substantially hitting exports to the UK, and upsetting financial markets. It has already been reported that consumer confidence across the Eurozone clearly weakened in July. The upsetting of the financial markets was highly evident in the immediate aftermath of Brexit; and while markets have since recovered, we suspect that there will be recurrent periods of volatility, particularly if negotiations between the UK and the EU on the way forward in their relationship appear to be going badly. Additionally, still significant banking-sector problems in some Eurozone countries will likely be aggravated by weakened Eurozone growth and, possibly, more difficult funding conditions. Currently, banking problems in Italy are a particular source of concern.

The Eurozone faces a number of growth-limiting factors in addition to the UK vote to leave the EU. Even before the UK leave vote, global growth remained muted and there have been persistent concerns that it could be held back over the coming months by limited economic activity in emerging economies, centred on a marked slowdown in China. This has limited Eurozone exports and has periodically weighed down on business and consumer confidence, along with financial market turmoil at the start of 2016.

There are also a number of domestic factors in the Eurozone that limit the upside for growth. Unemployment across the Eurozone is still relatively high (the jobless rate was 10.1% in May 2016, down from a peak of 12.1% in mid-2013) and is likely to trend downward gradually in the coming months. Meanwhile, private and public debt levels remain high in a number of countries. Consumer purchasing power is also being limited by muted wage growth in many countries. Meanwhile, credit conditions currently remain relatively tight in some Eurozone countries, despite recent overall improvement. In addition, real interest rates are too high for a number of Eurozone countries. Finally, structural problems and poor competitiveness continue to limit the upside for growth in a number of Eurozone countries, notably Italy and France.

Recurrent terrorist attacks in the Eurozone also pose a downside risk to Eurozone growth, mainly through affecting confidence, which could potentially weigh down on consumer spending, business investment, and tourism. Past terrorist attacks appear to have had only limited harm on growth with the French national statistics office (INSEE) estimating that the Paris bombings and attacks in November 2015 likely only shaved 0.1 percentage point off French GDP growth in the fourth quarter of 2015. Nevertheless, with the Brussels bombings in March and the Nice attack in July following only four months after the Paris attacks, there is the risk that repeated terrorist attacks combine to have more economic damage in the Eurozone.

Nevertheless, there are still a number of positives for Eurozone growth. The Eurozone should remain a significant beneficiary from extended relatively low oil and commodity prices. Although Brent oil prices have firmed from a more-than-12-year trough of USD27.10/barrel in mid-January to currently trade around USD47/barrel, they are still relatively low and are likely to remain muted for a prolonged period. Specifically, IHS Markit expects Brent oil prices will likely hover in a USD45–55/barrel range for an extended period before firming to USD60/barrel in the second half of 2017 (to average USD44.7/barrel in 2016 and USD57.0/barrel in 2017). Additionally, we believe that commodity prices will only slowly pick up. This should support consumers' purchasing power by keeping inflation low (consumer prices fell 0.1% year on year in May), and it should also significantly help companies' margins, which will support investment and employment. Meanwhile, the euro is still at a helpful level for Eurozone growth prospects, even though it has firmed from the nearly 12-year low of USD1.0457 seen in March 2015, to currently trade around USD1.10.

In addition to oil prices and the euro remaining at levels helpful for Eurozone growth, support should come from major European Central Bank (ECB) stimulus and a more growth-oriented fiscal stance. Indeed, the ECB introduced further major monetary stimulus in March 2016, cutting interest rates further, increasing its quantitative easing programme, and introducing more liquidity measures aimed at encouraging bank lending to Eurozone companies and households. Importantly, latest data and surveys indicate overall that credit conditions across the Eurozone have improved recently after having been tight for a prolonged period. Additionally, bond yields are low. Meanwhile, several countries, including France and Italy, are being given extended time to meet fiscal targets to help growth. Although Germany remains opposed to any easing of fiscal discipline among Eurozone members, it seems that more fiscal flexibility is being allowed in return for a firm commitment to structural reforms. Indeed, a number of countries have announced stimulus measures, and fiscal policy across the Eurozone looks set to be modestly expansive overall in 2016.

Meanwhile, labour markets have improved in most Eurozone countries. The number of Eurozone jobless fell a total of 2.247 million in the 18 months to May 2016, taking it down to 16.267 million, which is the lowest level since August 2011. This should support consumer spending in tandem with extended very low consumer price inflation or deflation. Meanwhile, there will likely be a growing need for many businesses to invest to replace or upgrade plants after extended weakness in capital spending.

Eurozone GDP growth is forecast to slow to 1.1% in 2017, primarily because of an increased hit from the spillover from Brexit. Economic and political uncertainties are seen more pronounced across the Eurozone in 2017, weighing down on business and consumer behaviour. Consequently, domestic demand growth is projected to moderate to 1.3% in 2017, with total investment growth halving to 1.5% and consumer spending growth slowing, albeit less markedly, to 1.4%. Public spending growth is projected at 1.4%. The negative drag from net trade is seen lessening in 2017 as Eurozone import growth moderated to 3.0% owing to softer domestic demand expansion. Export growth is seen limited to 2.3% in 2017, with sales to the UK particularly hit as the UK economy suffers markedly from Brexit uncertainties and concerns. Among the individual Eurozone countries, GDP growth is seen weakening across the board in 2017, although the slowdown is seen limited in Germany (1.4%) because of still reasonably healthy domestic fundamentals. Elsewhere, growth is seen at 1.6% in Spain, 1.3% in the Netherlands, 0.9% in Portugal, 0.6% in France, and 0.5% in Italy. Greece is seen returning to growth, albeit just 0.6%.