Eurozone GDP Growth Improves to 0.6% in Q1

Eurozone Economy Bounces Back in Q1

Eurozone GDP growth rebounded relatively well in the first quarter of 2006, having faltered in the fourth quarter of 2005, according to the ’flash’ estimate from Eurostat. Specifically, GDP expanded by 0.6% quarter-on-quarter (q/q) across the region in the first quarter. Growth had previously moderated to 0.3% q/q in the fourth quarter of 2005, from 0.7% q/q in the third. Meanwhile, the annual rate of Eurozone growth climbed to 2% in the first quarter of 2006, from 1.8% in the fourth quarter of 2005 and a low of 1.2% in the second and first quarters of 2005. The annual growth rate was boosted by the fact that Eurozone GDP had expanded just 0.2% q/q in the first quarter of 2005. Eurozone GDP growth was 1.3% over the whole of 2005.

Business Investment Likely to Have Seen Significant Improvement

Eurostat is yet to release the breakdown of the individual Eurozone GDP components in the first quarter of 2006, and only limited details are available so far from the individual countries. Nevertheless, it seems highly likely that the improved Eurozone growth performance in the first quarter was boosted significantly by higher business investment across the region. Exports also appear to have been relatively healthy overall, although any contribution from net trade was probably limited by higher imports. Meanwhile, consumer spending seems to have remained relatively muted overall in the first quarter, despite some reported improvement in Germany. Indeed, it has been reported that Eurozone retail sales volumes rose by just 0.1% q/q in the first quarter, although it needs to be borne in mind that retail sales account for around 40% of total consumer spending across the Eurozone.

Germany and Italy Return to Growth

The German economy returned to expansion (by 0.4% q/q) in the first quarter of 2006, after stagnating in the fourth quarter of 2005, although the annual growth rate eased back to 1.4% from 1.7% (unadjusted for working days, German GDP growth was 2.9% year-on-year in the first quarter due to there being three more working days in 2006 compared to 2005). Meanwhile, the Italian economy picked up to grow by 0.6% q/q and 1.5% year-on-year (y/y). It had also stagnated in the fourth quarter of 2005, when its annual growth rate was just 0.5%. France is yet to release its first-quarter GDP data.

The performances were somewhat mixed among the other Eurozone economies that have so far released details of their first-quarter GDP. Spain continued to achieve relatively robust expansion, growing by 0.8% q/q and 3.5% y/y. This was similar to the growth rates achieved throughout 2005. In addition, Belgian growth strengthened to 0.8% q/q and 2.2% y/y in the first quarter of 2006, from 0.6% q/q and 1.5% y/y in the fourth quarter of 2005. Greek GDP rose by 2.7% q/q in the first quarter, pushing the annual growth rate up to 4% from 3.7% in the fourth quarter of 2005.

However, the Dutch economy lost significant momentum, having bounced back pretty strongly in the second, third and fourth quarters of 2005. Specifically, Dutch GDP growth slowed to 0.2% q/q in the first quarter of 2006, from 0.6% q/q in the fourth quarter of 2005, although the annual growth rate actually accelerated markedly to 2.9% from 1.6%. The Austrian economy also lost some momentum, with GDP growth easing back to 0.5% q/q in the first quarter from 0.7% q/q in the fourth quarter of 2005. Nevertheless, annual growth improved to 2.3%, from 2%. Meanwhile, Finnish growth slowed to 0.4% q/q and 2.8% y/y in the first quarter of 2006, from 0.9% q/q and 2.9% y/y in the fourth quarter of 2005.

Outlook and Implications

We expect Eurozone GDP growth to be relatively robust throughout the second and third quarters of 2006. However, we are doubtful that it can sustain this performance for an extended period, given a number of potentially significant handicaps. Indeed, we expect Eurozone growth to start to lose some momentum towards the end of 2006. As a result, we believe that Eurozone GDP growth will rise from 1.3% in 2005 to 2.1% in 2006, then ease back to 1.7% in 2007.

There are currently signs that the euro could be beginning the substantial upward move that we have long anticipated. Indeed, the euro climbed to a one-year high of US$1.283 in early May, amid belief that the U.S. Federal Reserve will soon stop raising U.S. interest rates, while the European Central Bank (ECB) will continue to tighten Eurozone monetary policy. Meanwhile, the large U.S. current-account deficit remains a very significant threat to the dollar. Any sustained, significant strengthening of the euro would obviously be detrimental to Eurozone competitiveness. 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$74/barrel in April and May. We expect oil prices to stay very strong for some time to come, with Brent averaging US$65.8/barrel in 2006, compared with an average of US$54.4/barrel in 2005. It is seen easing back only marginally to US$63.5/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 later on in 2006 and in 2007. Specifically, we forecast global growth to soften from 3.7% in 2006 (similar to the estimated 2005 outturn of 3.6%) to 3.2% in 2007. U.S. domestic demand growth is expected to weaken significantly.

Meanwhile, Eurozone interest rates are now rising. Having kept its key interest rate at 2% for 29 consecutive months, the ECB lifted it by 25 points to 2.25% in early December 2005 and then by a further 25 basis points to 2.5% on 2 March. We expect the ECB to lift its key interest rate by a further 25 basis points in both the second (to 2.75%) and third (to 3%) quarters of 2006. We forecast the ECB to then keep the rate at 3% in the fourth quarter of 2006 and throughout 2007, although there is a very significant risk that it could hike rates further. In addition, Eurozone long-term interest rates have risen recently from very low levels and are likely to continue to trend gradually upwards.

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. This pressure is occurring despite the greater flexibility that has been incorporated into the Stability and Growth Pact (SGP) by the reforms seen in the first half of 2005. Indeed, fiscal policy will be restrictive overall in the Eurozone in 2006. While some governments appear to have become less prepared to improve public finances at the risk of stifling growth, the German coalition government has prioritised the reduction of the budget deficit. 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 2006 from 2007.

Furthermore, although generally limited in scope (and potentially beneficial for the long-term growth potential), actual and proposed structural reform plans in a number of countries - relating particularly to labour markets, pensions, healthcare, and welfare systems - are contributing to some uncertainty and concerns among businesses and, especially, consumers, thereby encouraging cautious behaviour.

Given the extended squeeze on companies' margins from high oil prices and the past strength of the euro - as well as some uncertainties about the global outlook and the awareness that the Eurozone has repeatedly suffered ’false dawns’ - we believe that firms will be relatively cautious about substantially further stepping up their capital expenditure, although investment is expected to be reasonably healthy going forward. Most significantly, we anticipate that Eurozone companies will remain reluctant to lift employment markedly unless absolutely necessary due to increased workloads, and will continue to seek when necessary to squeeze out as much extra output as possible from their existing labour forces.

Although labour markets have recently shown modest overall improvement across the Eurozone, unemployment is still generally very high, and marked, sustainable increases in employment have yet to be achieved. Consequently, consumers are likely to remain relatively cautious about substantially raising their expenditure, particularly as there are still significant concerns about personal finances. Furthermore, any sustained spike up in inflation because of strong oil prices may also weigh down on consumption (annual Eurozone consumer price inflation rose to 2.4% in April, from 2.2% in March). Significantly, consumer confidence across the Eurozone has not improved to the same extent overall as business confidence since mid-2005, even though it stood at its equal highest level since September 2002 in April.