Can Europe’s economy bridge the growth gap?

• After a sluggish pandemic response, Europe’s economy is expected to expand by 4.6% in 2021, after shrinking by 6.7% last year – but risks remain
• Improving vaccination rates across the continent are paving the way for an easing of COVID-19 restrictions and stronger growth
• The EU recovery fund also aims to boost growth prospects with green and digital investments – working towards a more sustainable future
• Given the European Central Bank’s limited room to move, the burden of stimulating the economy increasingly rests on fiscal policy.

After a relatively lacklustre economic response to the pandemic, global demand and excess consumer savings suggest the outlook is more encouraging, even if risks remain. Can the EU’s recovery fund help boost growth prospects further?

Europe’s road to recovery has been less assured than seen elsewhere in the developed world. Elevated coronavirus cases and the relatively lacklustre start to the vaccination programme forced governments to reintroduce restrictions. These stringent constraints have continued to weigh on economic activity.

The services sector has had a turbulent time through the pandemic and bottlenecks in global supply chains have also been disrupting the previously resilient manufacturing sector. The eurozone fell into a double-dip recession in the first quarter: output shrank 0.3% after contracting by 0.7% in the last three months of 2020.

Inoculation rates gather pace

On the positive side, the COVID-19 vaccination campaign has gained momentum over the past couple of months. At the start of June, 40% of the population in the continent’s four largest economies had received at least one shot of the vaccine, with weekly vaccinations picking up on improved vaccine supply. That said, inoculation hesitancy might eventually dampen high vaccination rates.

Falling infections, hospitalisations and ICU occupancy rates are paving the way for a gradual reduction of restrictions going into the summer. France has relaxed curfews while Italy and Germany have moved to lower risk tiers.

The EU’s Digital COVID Certificate, designed to demonstrate whether the holder has been vaccinated, recently tested or acquired immunity, was scheduled to come into use on 1 July. The “vaccine passport” should help facilitate travel between European states and may also pave the way for tourists from designated safe countries.

Lacklustre consumption

Euro area household consumption declined 2.3% in the first quarter and was still 10% lower than pre-crisis levels. Retail sales rates have fluctuated as lockdowns have come and gone, although the impact of restrictions has become more muted over time as households and firms have learnt to operate in an environment of containment.

Cautious consumers have increased saving rates to historically high levels over the past year, which when unleashed, should drive near-term consumption as economies reopen. However, surveys suggest that households are still cautious about planning major purchases over the next twelve months, reflecting uncertainty over the pandemic and job prospects.

Demand is also likely to be impacted by negative real disposable income growth in the coming quarters, given the recent acceleration of inflation, even if temporary, and subdued nominal wage growth.

Unemployment to remain elevated

In April the euro area unemployment rate was 8% (up from 7.1% in March 2020), meaning there were 1.4m more unemployed than last April. More than 5% of the bloc’s workforce are estimated to still be on furlough schemes and hours worked remains around 7% below pre-COVID-19 levels. We project that unemployment will remain elevated over the next two years, averaging 8.1% both this year and next. Global demand, business investment and residential construction should provide support.

Rising international demand and an easing of travel barriers are likely to assist euro area exports. This is particularly so for regions that are more open and integrated into the global industrial cycle.

Business investment rebounded in the second half of 2020, but is still around 10 % below its fourth-quarter 2019 peak. Inventory investment is lean, but we anticipate that firms will restock and invest in capital over the coming quarters. Housing investment has been weak, but mortgage demand is increasing and fiscal subsidies have been supporting green energy and residential construction.

Inflationary pressure not sustainable

The reversal of value added tax cuts, rising container shipping pricing and the sharp rebound in energy costs have all conspired to propel inflation readings higher of late.

Euro area inflation surged to 2% in May, its highest level in more than two years, with the gauge of price pressures topping the European Central Bank’s (ECB) target for the first time since 2018.

As we look beyond one-off, seasonal and technical factors, we expect inflationary pressures to return to more subdued levels. Weakness in labour markets and household disposable income should anchor core inflation at depressed levels. We forecast that the year-on-year consumer price index (CPI) will peak at 2.7% in the fourth quarter of this year, before softening. Next year we project inflation in the euro area will average just 1.4%.

ECB to focus on liquidity support

The relatively sluggish recovery and subdued medium-term inflationary environment suggests that the European Central Bank (ECB) will need to keep rates in negative territory for some time. We expect the deposit rate to remain at -0.5% over the next two years.

The bank’s focus is, instead, expected to remain on liquidity support. Its refinancing operation has undeniably helped liquidity and financing conditions. The central bank renewed its commitment to maintain its accelerated bond-buying at June’s meeting, despite its improved growth and inflation forecast.

Given the ECB’s limited policy options, the burden of reflating the economy and stimulating growth increasingly sits with fiscal policymakers.

European recovery fund aims to boost growth prospects

The recovery fund (Next Generation EU) was heralded as a significant step change for the bloc when it was unveiled last year. The plan allows the European Commission to borrow the money to finance the fund using guarantees from the EU’s long-term budget as security, thereby embracing shared debt liability.

The recovery fund promises to mitigate the economic and social impact of the pandemic and make European economies and societies greener, more digital and more resilient. Assuming the near €800bn of EU funding over five years is efficiently and effectively distributed, it could provide a real fillip to Europe’s growth prospects. However, political infighting, poorly coordinated investment priorities and slow progress on commitments to economic reforms have seen disbursement delays and risks hindering the recovery.

Growth outlook

While positive growth resumed in the second quarter, a more meaningful recovery in activity seems to have started in June. We forecast growth of 4.6% for 2021 and 4.4% for 2022 (see table) with output returning to pre-crisis levels by the second quarter of next year. Long-term, pronounced economic scarring, the scaling down of support measures and limited future fiscal space may result in a reversal back to a significantly weaker trend growth rate.

Source: Barclays Research, Barclays Private Bank, June 2021