Global Insight Perspective | |
Significance | The Eurozone economic upturn evident since the middle of 2005 strengthened further in the second quarter of 2006. |
Implications | The European Central Bank is likely to raise interest rates again before the end of the year as it believes that the ongoing strength of the Eurozone economy warrants less accommodative monetary policy. |
Outlook | We expect Eurozone growth to lose momentum over the coming months in reaction to slowing global growth, tighter fiscal policy, higher interest rates, still relatively high oil prices and an anticipated strengthening of the euro. |
Eurostat has confirmed that Eurozone GDP growth strengthened to 0.9% quarter-on-quarter (q/q) in the second quarter of 2006. This was the best performance since the second quarter of 2000, and followed robust expansion of 0.8% q/q in the first quarter. Consequently, the annual rate of Eurozone growth climbed to 2.7% in the second quarter, up from 2.2% in the first quarter and 1.8% in the last quarter of 2005.
Domestic Demand Buoyant
Robust domestic demand boosted Eurozone growth in the second quarter. In particular, gross fixed capital formation expanded by an impressive 2.1% q/q and 4.8% year-on-year (y/y), having grown 1.0% q/q and 3.8% y/y in the first quarter. Spending on capital equipment was relatively healthy across the Eurozone, supported by the marked improvement in Eurozone business confidence seen since mid-2005, as well as higher orders and production. For example, German expenditure on machinery and equipment expanded 2.5% q/q in the second quarter, having expanded 2.3% q/q in the first. In addition, French business investment increased 2.3% q/q in the second quarter, the third marked rise in four quarters (although there was a modest correction in the first quarter).
However, Eurozone consumer spending growth moderated to 0.3% q/q and 1.7% y/y in the second quarter. It had previously rebounded to 0.7% q/q and 1.8% y/y in the first quarter, compared to just 0.1% q/q and 1.1% y/y in the fourth quarter of 2005. The moderation in Eurozone private consumption growth in the second quarter was largely the consequence of German consumer spending contracting by 0.4% q/q. The burden from high oil prices and newly emerging concerns about the ability of the new "grand coalition" government to introduce further reforms to deal with Germany’s structural problems in the labour market and the social security system seem to have been restraining factors.
Nevertheless, improving consumer confidence and recent modest improvements in Eurozone labour markets should support consumer spending in the latter months of 2006, especially as some spending is likely to be pulled forward in Germany as a consequence of the three-percentage-point rise in value-added tax (VAT) that is to be enacted in January 2007.
Government spending increased 0.5% q/q and 2.3% y/y in the second quarter, having expanded by 0.9% q/q and 2.5% y/y in the first. Meanwhile, inventories made a positive contribution to growth of 0.2 percentage point in the second quarter. This contrasted with a negative contribution of 0.4 percentage point in the first quarter.
Net Trade Makes Modest Positive Contribution
Net trade contributed 0.1 percentage point to overall Eurozone GDP growth in the second quarter, having lifted first-quarter growth by 0.4 percentage point. Export growth decelerated to 1.2% q/q and 8.6% y/y in the second quarter, from 3.6% q/q and 9.3% y/y in the first quarter. Eurozone exports were supported in the first half of 2006 by relatively healthy global growth. In addition, the oil-producing countries, which have obviously had their wealth boosted by persistently very high oil prices, are significant consumers of European products. However, the euro firmed in the second quarter, which may have had some dampening impact on Eurozone exports. Specifically, the euro neared US$1.30 in June, having frequently dipped below US$1.20 in the first quarter of 2006 and the second half of 2005. Meanwhile, Eurozone import growth slowed to 1.2% q/q and 8.2% y/y in the second quarter, compared to 2.7% q/q and 9.7% y/y in the previous quarter.
German and French Growth Improves
Among the individual Eurozone economies, German GDP grew by 0.9% q/q in the second quarter, which was the best performance since the first quarter of 2001. This followed expansion of 0.7% q/q in the first quarter and 0.3% q/q in the final quarter of 2005. Annual German growth strengthened to 2.4% in the second quarter, from 1.7% in each of the two preceding quarters. Domestic demand was responsible for almost all of the 0.9% q/q GDP growth in the second quarter, with investment and a build-up of inventories the key driving forces.
Furthermore, French GDP growth improved markedly to 1.2% q/q and 2.6% y/y in the second quarter from 0.4% q/q and 1.4% y/y in the first (when it was held back by a substantial reduction in inventories). Meanwhile, Italian GDP growth was a respectable 0.5% q/q in the second quarter, although this was down from expansion of 0.7% q/q in the first quarter. Annual Italian growth edged back to 1.5% in the second quarter, from 1.6% in the first. Meanwhile, Spanish GDP was up an impressive 0.9% q/q and 3.7% y/y in the second quarter, similar to the first-quarter expansion of 0.9% q/q and 3.6% y/y.
Dutch GDP surged 1.2% q/q in the second quarter. This was the best performance since the first quarter of 2004 and up from growth of 0.5% q/q in the first quarter of 2006. Year-on-year growth was 2.8% in the second quarter. Austrian GDP growth improved to 0.9% q/q and 3.3% y/y in the second quarter, from 0.6% q/q and 3.1% y/y in the first. Moreover, Belgian growth held up well at 0.8% q/q and 2.8% y/y in the second quarter, after expanding 0.9% q/q and 2.3% y/y in the first quarter.
Meanwhile, Finland was the strongest-expanding Eurozone economy in the second quarter, with GDP jumping 1.9% q/q and 6.6% y/y. This followed expansion of 2.1% q/q and 4.7% y/y in the first quarter. In addition, Ireland continued to enjoy very robust economic activity, although its annual growth rate eased back to 4.9% in the second quarter from 5.7% in the first.
Outlook and Implications
The latest data and survey evidence indicates overall that the Eurozone economy is currently continuing to grow relatively well. However, it is highly likely that activity peaked in the second quarter. Indeed, we expect Eurozone growth to lose some momentum late in 2006 and during 2007, given a number of potentially significant handicaps to growth. As a result, we believe that Eurozone GDP growth will rise from 1.4% in 2005 to 2.5% in 2006, and then ease back to 1.7% in 2007.
We expect the euro to trend higher against the U.S. dollar over the coming months, which would obviously be detrimental to Eurozone competitiveness and growth prospects. Specifically, we forecast the euro to rise to US$1.30 by the end of 2006 and then to climb to US$1.40 by the end of 2007 as the dollar is pressurised by less favourable interest-rate developments in addition to the large U.S. current-account deficit. Furthermore, very strong oil prices are likely to remain a threat to growth for some time, given the very tight global supply-demand situation for oil. Indeed, Brent oil traded at new record highs above US$78/barrel in early August. Although oil prices have since fallen back markedly (Brent traded dipped under US$60/barrel in September and traded as low as US$55.5/barrel in early October), we suspect that they will remain prone to upward spikes and generally strong for some time to come. We currently forecast Brent oil to average US$67.4/barrel in 2006 and US$66.6/barrel in 2007.
In addition, any slowdown in global growth is also a significant threat to Eurozone growth prospects, given that improved exports and healthier foreign orders for Eurozone products have been key factors in supporting the marked overall improvement in both growth and business confidence across the region since mid-2005. While global economic activity currently remains relatively healthy, Global Insight nevertheless forecasts it to moderate in the latter months of 2006 and in 2007. Specifically, we forecast global growth to soften from 3.9% in 2006 to 3.2% in 2007. U.S. domestic demand growth is expected to weaken significantly.
Meanwhile, Eurozone interest rates have risen significantly, and are likely to increase further still. Having kept its key interest rate at 2.00% for 29 consecutive months, the European Central Bank (ECB) has raised interest rates by a cumulative 125 basis points between December 2005 and October, taking it up to the current level of 3.25%. The ECB has indicated that monetary policy is likely to be tightened further, and we expect it to lift the key interest rate by a further 25 basis points to 3.50% in December. We forecast the ECB to then keep the rate at 3.50% throughout 2007, although we acknowledge that there is a very real possibility that the ECB could tighten monetary policy further. In addition, Eurozone long-term interest rates have risen modestly overall from the very low levels seen earlier in 2006.
Not only does the Eurozone seem set to see tighter monetary policy over the coming months, but pressure remains on many Eurozone governments to tighten fiscal policy to improve weakened public finances. Indeed, fiscal policy will be restrictive overall in the Eurozone in 2006 and 2007. Significantly, the German coalition government has prioritised reducing the country's budget deficit, while the new centre-left Italian government has indicated that it will enact substantial spending cuts as part of the major corrective action needed to bring public finances back under control. Given that the German government has announced that sales tax will rise by three percentage points in January 2007, however, some consumer spending could be brought forward to the final months of 2006 from 2007.