Today’s meeting of the European Central Bank’s (ECB) governing council wasn’t particularly eventful—yet it does provide a good opportunity to keep tabs on the Eurozone’s economic environment and policies. Here is our view of the highlights:
- Today’s meeting of the ECB governing council was largely routine. That’s because the ECB already decided, in December of 2016, to extend its quantitative easing program to the end of 2017. Assuming that no major economic shocks occur, we do not expect the ECB to enact any changes to its policy in the coming months—with the exception of perhaps occasional technical tweaks along the way—until new economic data begins to accumulate and point to possible next steps.
- We expect the ECB’s quantitative easing program to go beyond 2017. The tone of today’s ECB press conference was in line with our assessment and expectations, which are that the Eurozone’s economic recovery is on track, and that growth has picked up a bit recently. Inflation is rising mainly due to a base effect in the form of rising energy prices. Since the ECB has not yet achieved a broad-based acceleration in the inflation rate, it needs to continue pursuing monetary stimulus until there is clear progress toward price stability. Thus, we expect it to continue its quantitative easing program next year.
- The Eurozone economy concluded 2016 with impressive resilience despite various shocks, and gained momentum going into 2017. The last set of economic survey indicators for 2016 were promising, including the Purchasing Managers’ Index (PMI), an indicator of the manufacturing sector’s economic health. The final Composite PMI for December was 54.4—its highest level since May 2011. New orders, which are the forward-looking component of the PMI, are pointing upward and suggest a pickup in economic activity.
PMI indicators on the country-by-country level—not just the Eurozone level—were also promising, by and large. In Germany, France and Spain, PMIs are trending upward, while Italy showed a marginal decline but remains at an expansionary level. Similarly, the European Commission economic sentiment index (ESI) for the area is also at multi-year highs (Exhibit 1).
Finally, consumer confidence continues to improve and is above the long-run average.
- Hard economic data, which thus far is limited to the fourth quarter of 2016, confirm the Eurozone’s recovery trend. Retail sales in the first two months of the fourth quarter were higher than in the previous quarter and suggest solid growth in consumption. Industrial production data has also been improving since the summer. The Eurozone’s overall unemployment rate, as of November 2016, was at 9.8%, the lowest since the summer of 2009.
- We expect the Eurozone’s economic momentum to continue in 2017. As we discussed in two previous blogs (“ECB’s Draghi Sets Stage for QE Extension” and “Eurozone Resilient Post-Brexit but ECB Not Done”), the main drivers of Eurozone growth are domestic, and they remain intact. Job creation, improving consumer confidence, and the opening up of the credit markets allow consumers to spend and contribute to growth.
We are not suggesting that consumer deleveraging is over, but progress has been made on that front, and Europe’s credit markets are recovering as a result. Capital expenditures are rebounding, with room to expand further as the recovery in investment has been very timid throughout this cycle as compared with the Eurozone’s own history and with other advanced economies.
Even residential investment, which following the financial crisis of 2008-2009 used to be a drag on the economy and has since recovered from its deep lows, is now contributing to growth.
Finally, fiscal policy, another major drag before 2015, contributed to growth in 2016. Some commentators expect less of a boost from government expenditures to growth in 2017, but we beg to differ. In a year of several important political elections, we find it difficult to foresee a push for tighter fiscal policy as compared with last year.
- Inflation in Europe is at its highest level in three years thanks to rising energy prices. The decline in energy prices in 2015 and 2016 was so significant that it offset the rise in the prices of services, food and non-energy industrial goods, and reduced the Eurozone’s overall inflation rate—occasionally even to negative levels. This trend is now largely over, and on the basis of oil-futures prices, we believe that energy will be a positive contributor to inflation in the coming months, but that its effect will likely recede toward the end of the year.
Underlying inflation in the Eurozone is still significantly below the ECB’s definition of price stability, and doesn’t have significant upward momentum. Moreover, inflationary pressures throughout the Eurozone are subdued. True, the economy is growing above its potential, but in many countries there is still considerable slack. Cost pressures, particularly wage growth, are limited. For these reasons, though we expect core inflation to gradually rise, we believe core inflation will still be significantly below target at the end of this year and will require continued monetary stimulus from the ECB.
For the time being we will keep a close watch on the ECB’s September meeting, during which we expect it to announce an extension of its quantitative easing program into 2018, while tapering the amount of its bond purchases.
With rates on the front end of the yield curve anchored by the ECB, we expect that the yield curves in Europe will continue to steepen as global rates rise over time. In addition, given the ECB’s stance and the Eurozone economy’s ongoing recovery, we expect European corporate bonds will likely continue outperforming sovereign bonds, and that the steeper yield curve may be beneficial for the financial sector.
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