European outlook: a green recovery plan

19 November 2020

7 minute read

By Henk Potts, London UK, Market Strategist EMEA

As the European Central Bank struggles to simulate growth at a time of plunging demand, can innovative fiscal measures take up the slack and deliver a greener post-pandemic.

The eurozone entered its deepest recession since World War Two this year, amid the initial economic shock from soaring COVID-19 infections, posting a double-digit contraction in the second quarter from the prior one. The following quarter’s recovery was led by France and Spain, driven by pent-up household demand, business investment and net trade. However, varying degrees of fresh lockdowns, disrupted global trade and pressure on domestic demand adds to the risk of a double-dip recession occurring. The outlook for the economy in large measure seems to rest on coronavirus developments.

The eurozone is a relatively open economy that has profited from growing international trade links over the past two decades. The European Central Bank (ECB) estimates that “extra-euro area” trade in goods and services amounts to around half of the bloc’s gross domestic product (GDP).

Weaker international demand and disruption to trading routes as a direct result of the pandemic is expected to reduce Europe’s trade with the rest of the world by a weighty 10% this year, according to data from the European Union (EU). Manufacturing has been hit hard, particularly transportation and electrical equipment.

Unemployment set to soar

Higher levels of unemployment resulting from the economic contraction seen this year will inevitably weigh on household consumption levels. Nervousness around the labour market has pushed savings intentions to their highest level on record. Labour markets in the eurozone tend to fluctuate less than seen in the US due to a broad mix of legal protections for workers and the power of the unions in the region.

The eurozone unemployment rate was 7.9% before the pandemic took hold. The number of workers without jobs has jumped significantly since August. With support measures being gradually unwound, unemployment levels may rise dramatically into the year end. We expect a eurozone unemployment rate of 9.1% by the end of 2020, remaining elevated through 2021 to finish at 9.4%

Subdued inflationary pressures

The eurozone’s inflation figures turned negative in August for the first time in four years, highlighting the lacklustre demand seen in the bloc. Consumer price inflation (CPI) was -0.2% while core inflation, which strips out the volatile food and energy component, hit a record low. Looking beyond the seasonal and technical factors, subdued eurozone inflation is likely next year too, with weakness in labour markets and household disposable income anchoring core inflation at depressed levels.

Moreover, autumn’s resurgence of COVID-19 cases in Europe poses a meaningful risk to the consumer demand recovery and could create additional downward pressure. Inflation should trend up in 2021 as base effects recede, but we expect that CPI will average 0.4% next year, well below the target level.

ECB fires another bazooka

The ECB has taken aggressive measures to stabilise the economy and provide favourable financing facilities to businesses and households, which is helping to support demand. With European rates already deep in negative territory, the central bank has limited room for manoeuvre. As such, the deposit rate may remain at -0.5% for the next two years with the bank’s Governing Council focusing on providing liquidity support.

ECB president Christine Lagarde fired her own big bazooka over the summer. In June, the Pandemic Emergency Purchase Programme was increased by €600bn. The total of announced purchases was €1.35 trillion1 at the end of October, much larger than seen in the euro crisis early in the last decade. That said, with a rapidly deteriorating health situation, a faltering recovery and subdued inflation outlook means that the ECB may have to take additional measures. In October the bank unusually pre-committed to recalibrate its instruments at December’s meeting in an effort to avoid unwarranted tightening of financial conditions.

The ECB is expected to extend its bond-buying programme by €500bn and commit to reinvestment until mid-2023. Its refinancing operation has undeniably helped liquidity and financing conditions. The targeted longer-term refinancing operations (TLTROs) rate can be cut further below -1% to encourage greater bank lending to the real economy if needed too. While the bank is proving to be resourceful, its limited policy tool kit means that it has struggled to reflate the economy and stimulate the required growth, a burden that increasingly sits with fiscal policymakers.

Debt binge to aid recovery fund

The extraordinary measures instigated by European officials will impact eurozone debt levels. The debt to GDP ratio is likely to hit 106% this year, from 86% in 2019.

The establishment of the European recovery fund by the European Commission (EC) is considered a significant step change for the bloc. The fund comprises of €390bn of grants and €360bn of low interest loans2. The plan proposes establishing a green recovery roadmap for each industrial sector and meeting the EU’s 2050 target for greenhouse gas emissions reductions. The proposal also takes a significant step in outlining the future of the EU in the long run with money made available for digitalising the economy and investing in research and innovation.

The EC plans to borrow the money to finance the recovery fund, using guarantees from the EU’s long-term budget as security and seemingly embracing shared debt liability. The proposal not only supports weak economies (particularly southern European ones) but commits to much greater levels of fiscal integration; a decision that reduces concerns about the fragmentation risk of the EU. While the European Council and Parliament are still negotiating the specific details of the fiscal package, speed is of the essence as political infighting could result in expensive implementation delays.

Eurozone recovery prospects

The eurozone is likely to contract in the final quarter of the year, taking the annual slump in activity to -7.2% in our view. Growth prospects will be determined by the path of the pandemic, resilience of the labour market and efficacy of the coordinated fiscal and monetary response. We expect the 27-member bloc to grow by 2.6% next year, which would be a poor performance when viewed through the lens of the low base of 2020.

Outlook 2021

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