What next for the eurozone economy?

Strengthening eurozone economic data has driven sharp rises in the euro over the past year. In the 12 months to the end of November the euro was up by 11% against the dollar and over 9% against the yen.

The eurozone economy has certainly gathered pace.

Growth jumped markedly in the fourth quarter of 2016, rising to 0.7% versus 0.4% in the prior quarter. The eurozone economy has since maintained decent growth, expanding 0.6%, 0.7% and 0.6% in the first, second and third quarters of 2017 respectively.

The European Commission expects the eurozone to grow by 2.2% this year, its fastest pace in a decade.

This forecast compares with the International Monetary Fund´s (IMF)  prediction for 2.1%, a significant improvement on last year´s 1.8%. At the same time, the IMF expects eurozone growth to moderate to a 1.9% pace in 2018.

Manufacturing strength

At the centre of the eurozone´s strong performance this year is Germany´s manufacturing sector. It´s export-orientated nature means the German economy tends to be a natural beneficiary of accelerating global growth.

This year, the world economy is set to grow by 3.6% versus the 3.2% pace of 2016, before accelerating slightly more to 3.7% in 2018, according to the IMF´s latest projections.

Data released today showed German factory orders beat expectations yet again in October, registering a third consecutive month of gains.

Germany´s October factory orders rose to 0.5% in October month-on-month, while September´s gain was upwardly revised to 1.2% from a prior 1% estimate.

Last week, the IHS Markit factory purchasing managers index (PMI) for the eurozone came in at a red hot 60.1 for November, up from 58.5 in the prior month. It’s the highest reading for the survey of activity in the eurozone manufacturing sector for over 17 years.

German cars ready for delivery.

Inflation

Eurozone inflation, however, has been disappointing forecasts of late. After jumping from a low of 1.1% in December last year, eurozone inflation reached a peak of 2% in February. It had fallen back to a low of 1.3% in June and July.

Inflation moderated to 1.4% in the year to October from 1.5% in September, well below the European Central Bank´s (ECB) 2% target.

Indeed, in September, the recent strength in the euro prompted the ECB to lower its inflation forecast for 2018, from 1.3% to 1.2%, due to the dampening impact that the strong euro is having on the prices of imported goods.

Unemployment

Over the past year, eurozone unemployment has dropped from 9.6% to 8.8%, its lowest level since early 2009.

While this is a move in the right direction, it´s still woefully high by international standards.

It compares with 2.8%, 4.1%, and 4.2% in Japan, the US and UK respectively.

At the same time, the varying rates of unemployment across the eurozone underline the huge economic disparity between some of its member countries.

Germany´s rate of unemployment is just 3.6%, comparing highly favourably with other major global economies.

Meanwhile, France appears an altogether different economy on this measure, with unemployment stuck at 9.8%.

It’s a horrible statistic, but there´s worse; Spain and Italy have unemployment rates of 17.1% and 11.2% respectively.

Further down the table, ailing eurozone member Greece has unemployment of 21%.

Monetary policy

The ECB began quantitative easing a little later than the US, which may go some way to explaining why the former is still conducting asset purchases.

As can be deducted from some of the aforementioned high rates of unemployment across the eurozone, many of the bloc´s economies are still trying to recover from the shock of the financial crisis, global recession and eurozone debt crisis.

Having cut interest rates to 0%, where they remain today, the ECB eventually embarked on a significant quantitative easing programme.

The ECB is still in the throes of gradually weaning the eurozone economy off this stimulus, which has included the purchases of eurozone government bonds and corporate debt.

In October, the ECB said it would reduce asset purchases to €30bn per month from early next year, down from the current €60bn.

This followed an earlier reduction announced in 2016, from €80bn per month.

Provided the eurozone economy keeps growing at a decent pace, the ECB could be in a position to announce that it is ending quantitative easing at some point next year.

However, it could be a while yet before the ECB contemplates a rise in interest rates from the current 0%.

Frankfurt skyline with European Central Bank.

Eurozone outlook

In an economic outlook last week, the OECD said it did not expect the ECB to begin raising interest rates until 2020, citing continued slack in European labour markets and subdued inflation.

Crucially, the IMF is actually forecasting a modest slowdown in growth for the eurozone economy in 2018 compared with this year.

Summing up the eurozone´s prospects, the IMF concludes: “The medium-term outlook for the euro area remains subdued because projected potential growth is held back by weak productivity, adverse demographics and in some countries, a public and private debt overhang.”

The latter is a salient point, especially as euro members Greece, Portugal, Ireland, Spain and Cyprus were all forced to seek third-party bailouts in the aftermath of the financial crisis.

Political risk

In the summer, much was made of the apparent reduction in political risk for the eurozone, as populist movements were defeated in Dutch and French elections.

More recently, the dismal polling of Angela Merkel´s party in September´s German federal elections and her subsequent failure to establish a coalition government, has brought eurozone political risk back to the forefront.

Spain has also been locked in a political crisis, taking drastic measures to quell independence aspirations in its Catalonia region.

Euro strength

Against the backdrop of lower inflation expectations and a possible deceleration in the eurozone economy next year, we may not see much more euro strength on the immediate horizon.

On the other hand, performance versus the dollar will also hinge on events in the US, especially as Donald Trump´s administration appears to be on shaky ground.

Over the longer term, the euro´s future could be less bright. When the global economy does weaken again, and European exporters see some slowdown in demand, Europe´s political backdrop may also prove to be a bigger concern for investors.