Developed Europe: Regional Economic Review – Q1 2014

Recovery Gains Momentum, but Persistently Low Inflation Remains a Concern

Most of the recent news from Developed Europe show that the region’s economic recovery stood on firmer ground at the end of the first quarter. For instance, the European Commission’s (EC) Economic Sentiment Indicator remained in an uptrend for both the 18-nation Euro-zone and the broader 28-country European Union (EU) throughout the quarter. The EC’s Business Climate Indicator for the Euro-zone also climbed steadily during the period. Similarly, financial information services provider Markit’s closely followed Composite Purchasing Managers’ Index (PMI) for the Euro-zone, which tracks activity in both the manufacturing and the services sectors, jumped in January and February, although it recorded a tiny slip in March.

Notably, the services sector, which is driven by business within the Euro-zone, accounted for a significant part of the rise in the composite PMI, indicating an uptick in regional economic activity. In contrast, the manufacturing sector, which is considerably reliant on exports to countries outside the Euro-zone, remained subdued owing to the slowdown in several emerging markets. What’s more, according to the European Union’s statistics office Eurostat, retail sales in the Euro-zone increased in February and March, which added to the evidence that household optimism is growing in the currency bloc. In fact, the EC has said that a jump in consumer confidence played a key role in its Economic Sentiment Indicator for the Euro-zone rising in March. All these data are especially heartening because they show that Developed Europe was largely able to defy concerns about the fallout of the crisis in Ukraine during the first quarter.

At a Glance

Germany:Tensions between Russia and Ukraine over the Crimean peninsula weighed on sentiment about Germany. However, GfK’s forward-looking consumer sentiment indicator surged to a seven-year high in March. In the first quarter, Germany posted a GDP growth of 0.8%, which exceeded expectations and was double the rate of growth clocked in the previous quarter.

U.K.:At the end of March, the U.K. remained on track to be one of this year’s fastest-growing developed economies. The economy expanded 0.8% in the first quarter compared to the previous quarter. The consumer inflation rate though remained muted at 1.6% in March, below the Bank of England’s (central bank) target rate of 2%.

France:GDP failed to grow between January and March, weighed down by declines in exports and household expenditure. Consumer spending declined 0.5% in the first quarter. The French parliament recently vetted a 50 billion euro plan to bring down the budget deficit below the EU ceiling of 3 percent of GDP by next year.

Italy:Against expectations that it may grow modestly, the Italian economy shrank 0.1% during the first quarter compared to the fourth quarter. The unemployment rate remained stubbornly stuck at 12.7% all through the quarter.

Spain: At the end of the first quarter, Spain’s recovery held steady, with the GDP expanding 0.4% for the period. The growth was driven by a small rise in domestic demand, which is a sign that the economy is no longer reliant only on exports.

Nonetheless, the overall story is that the Euro-zone remains dependent on exports for a sustainable and broad-based recovery as Europeans are believed to be still reluctant to spend freely amidst the record high unemployment levels and the muted economic climate in their region. Not surprisingly, the Euro-zone’s annual consumer inflation stood at 0.5% in March, its lowest level since 2009 and significantly lower than the European Central Bank’s (ECB) target inflation rate of below, but close to, 2%. What’s worse, according to the EC’s monthly surveys, a measure of Euro-zone consumers’ inflation expectations for the next one year declined every month between October and April.

In addition, manufacturers’ selling price expectations have remained in a downtrend. Given this consistently subdued level of price growth, the Euro-zone remains vulnerable to deflation, or a general decline in prices that is known to create a vicious cycle of falling profits, wages, and employment. In fact, some economists believe that in order to stimulate the economy, the ECB may soon follow other central banks in the developed world and launch some form of “quantitative easing” (QE) or measures that may enhance liquidity in the financial system and push up prices. On a happy note though, the Euro-zone economy appears to have taken its best step forward into the second quarter. Driven by a spurt in new orders, business activity in the currency bloc grew at its fastest pace in three year at the. start of the current quarter. In particular, service sector activity increased to its highest level in 34 months.

GERMANY: UKRAINE CRISIS WEAKENS SENTIMENT, BUT ECONOMIC OUTLOOK STILL VERY STRONG

For a major part of the first quarter, tensions between Russia and Ukraine over the Crimean peninsula weighed on sentiment about Germany. Europe’s largest economy buys more than a third of its gas and crude-oil requirements from Russia. Moreover, several big and mid-sized German firms have a fairly large presence in Russia. So, investors and businesses worried about the impact of any escalation in the crisis on the German economy. The closely watched ZEW indicator of economic expectations for Germany remained in a downtrend during the first quarter, falling to its lowest level since August in March and declining further in April.

However, ZEW has confirmed that the indicator’s current levels do not indicate any loss of momentum in Germany’s economic upswing. Indeed, households in the country appear to have remained optimistic about their economic climate, given that the Germany-based market research institute GfK’s forward-looking consumer sentiment indicator surged to a seven-year high in March and stayed there in April. This is rather encouraging since Germany, an export powerhouse, has largely been able to shrug off the slowdown in its key overseas markets, such as the Euro-zone, China, and other emerging economies, on the back of robust domestic demand. In the first quarter, Germany posted a GDP growth of 0.8%, which exceeded expectations and was double the rate of growth clocked in the previous quarter.

Moving forward too, German authorities expect the nation’s low unemployment rate and strong wage growth, as well as the record low interest rates in the Euro-zone to continue to boost domestic consumption. The expectations are not misplaced, as the strength and stability of Germany’s labor force remains one of the key drivers of consumer spending in the country. An indicator of this strength is payroll tax revenue, which soared 7.5% year-on-year in March to push up the German government’s total tax revenue 7.2%. The Economics ministry has declared that domestic activity, especially in the industrial and construction sectors, should push up German GDP at least 1.8% in 2014 and 2% in 2015.

THE U.K.: ON TRACK TO BE ONE OF 2014’S FASTEST-GROWING DEVELOPED ECONOMIES

At the end of March, the U.K. remained on track to be one of this year’s fastest-growing developed economies. The International Monetary Fund (IMF) has predicted that in 2014, Britain will see the quickest pace of economic expansion among the Group of Seven (G7) advanced economies. Quite in tune with this forecast, the U.K. economy expanded 0.8% in the first quarter compared to the previous quarter. Remarkably, GDP in the first quarter was 3.1% greater than it was in the same period last year, which means this was the fastest annual growth Britain has clocked in more than six years. What’s more, with this, the U.K. economy recorded its fifth consecutive quarter of growth.

The Office for National Statistics (ONS), which reported the GDP data, said that all the three key sectors of the economy contributed to the stellar performance. Activity in the all-important services sector, which accounts for more than three quarters of GDP, recorded its strongest growth since the third quarter of 2012. Industrial output grew at its quickest pace since the second quarter of 2010 while construction activity registered a relatively smaller rate of growth despite being hurt by bad weather in January and February. The icing on the cake is that while the economy has been advancing at a brisk pace, the consumer inflation rate remained muted at 1.6% in March, below the Bank of England’s (central bank) target rate of 2%.

Consequently, the central bank now has the leeway to keep its benchmark interest rate at current low levels for some more time and allow growth to accelerate without stoking inflation. Indeed, the Bank of England has indicated that it is not going to raise interest rates in a hurry. In any case, one of the discouraging aspects of the British economy is that it is still 0.6% smaller than it was in March 2008. So, while other economies like the U.S., Germany, and France have grown beyond their pre-crisis levels, the U.K. has some ground left to cover.

Fortunately, Britain’s outlook for the coming quarters remains positive. The dominant services sector continues to flourish — in April, it clocked its fastest pace of growth so far this year. The same month, business and consumer confidence in the country soared to their highest levels since 1990.

FRANCE: GDP GROWTH STALLS AS CONSUMER SPENDING DIPS

During the first quarter, the Euro-zone’s second largest economy remained the laggard among its regional peers. France’s GDP failed to grow between January and March, weighed down by declines in exports and household expenditure. The French economy had expanded 0.3% in the final quarter of 2013 and it was expected to grow at least 0.2% in the first quarter. Instead, the economy merely managed to avoid a contraction, thanks to some amount of government spending and inventory additions by businesses.

Over the past two years, France has not seen the kind of deep recession some of its Euro-zone neighbors have suffered. However, the country has swung between contractions and nominal growth, bogged down by problems, both old and new. From a structural perspective, French manufactured goods have been losing competitiveness in the global marketplace largely due to the rigid labor laws in the country. Consequently, French firms have moderated both hiring and investment in recent quarters, and not surprisingly, the unemployment rate in the country has been hovering around double-digit levels for a while now. It is widely believed that in this climate, France’s woes have been compounded by the sharp tax hikes President Hollande has introduced since coming to power in May 2012. Discouraged by the weakness in the labor market and sales tax hikes, French consumers have become more tightfisted lately. Consumer spending declined 0.5% in the first quarter.

The good news is that the government has changed its approach since the beginning of this year — from raising taxes in a bid to curb the budget deficit, it is now focusing on cutting taxes to boost both household and corporate spending. Tax cuts for the low-paid are in the pipeline and tax incentives are being offered to firms that commit to more hiring and investment. However, the full impact of these measures is yet to be felt in the economy, as the most recent GDP figures indicate. In another development, the French parliament recently vetted a 50 billion euro plan to bring down the budget deficit below the EU ceiling of 3 percent of GDP by next year.

ITALY: GDP SLIPS AGAIN, BUT REFORMS ON TRACK

The Euro-zone’s third largest economy reported several discouraging data for the first quarter. Against expectations that it may grow modestly, the economy shrank 0.1% during the period compared to the fourth quarter of 2013, when it had expanded 0.1% to emerge from its longest recession since World War II. Adding to the bad news, the country’s public debt, which at about 130% of GDP is one of the largest in the Euro-zone, climbed to $2.91 trillion in March. In another setback, the Mediterranean nation’s industrial production dropped in both February and March. Further, all through the three months of the first quarter, Italy’s unemployment rate refused to budge from its record high level of 12.7%.

The latest contraction in the economy has made it difficult for GDP to expand in line with the government’s growth target for 2014. After cutting the official GDP forecast once, the Italian Prime Minister Matteo Renzi now expects Italy’s output to increase 0.8% this year. However, recent estimates by the EC and the Italian national statistics institute Istat peg Italy’s 2014 growth rate at 0.6%. It is important for the Italian economy to grow as Matteo Renzi expects because slower growth may hinder the government’s ability to curtail its debt and budget deficit according to the targets specified by the EC.

The highly indebted government is perpetually under pressure from its creditors — or investors that hold its bonds — to not only keep its debt under control but also enhance Italy’s growth potential through structural reforms. The good news is that after a long period of political uncertainty, which saw four prime ministers in 30 months and severely obstructed politically difficult reforms, Matteo Renzi has taken some noteworthy steps since taking office in February. For instance, he was recently applauded by investors and corporate Italy for changing an archaic labor law and making it possible for firms to retain temporary workers for up to 36 months instead of 12.

SPAIN: RECOVERY GAINS VIGOR WITH RISE IN DOMESTIC SPENDING

At the end of the first quarter, Spain’s recovery held steady, with the GDP expanding 0.4% for the period to record its highest rate of growth since 2008. Still, several commentators have surmised that this pace of growth is likely not adequate for the country to reduce its stubbornly high unemployment rate, which stands at 25.93% now. The silver lining though is that the first-quarter growth was driven by a 0.3% increase in domestic demand. What’s more, the Bank of Spain (central bank), which released the data, believes that spending by Spanish consumers may continue to increase in the coming months to notch up its first yearly rise in six years.

Domestic consumption is such a significant factor of growth for Spain, especially at this phase of its recovery, that many analysts and authorities have taken a cue from the central bank’s assessment and revised upwards their forecasts for the country’s overall growth in 2014. Following a property-bubble burst in 2008 and a subsequent banking crisis, Spain suffered one of the severest recessions in its history. The Western European nation emerged from the downturn in the third quarter of 2013 on the back of strong exports, which surged as high unemployment pared labor costs and made Spanish goods substantially more competitive in the global market, especially within the Euro-zone.

However, the economic revival has been largely lopsided because other parts of the Spanish economy that are not related to its export sector continue to be in a slump. Exports account for only 35% of Spain’s GDP and the country can hope to achieve a broad-based, sustainable recovery only if domestic demand is revived. Consequently, the recent spurt in consumer spending is being seen as a sign that strong exports have resulted in more investments and hiring, which in turn have added to consumption. Besides contributing to overall GDP, stronger consumer spending is expected to help thousands of small- and medium-sized Spanish firms that do not sell their goods outside Spain.

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