EUROZONE: BEYOND THE ROCKY SUMMER

Torn between solid economic fundamentals at home and a series of political and external risks, European markets have struggled to find a direction this year. On balance, we have seen more of a move into risk-off territory (low Bund yields, wobbly equities, stronger USD and CHF) than a continuation of last year‘s risk-on trends (stronger equities, tighter yield spreads, stronger EUR). Our base case remains unchanged: economic fundamentals will prevail in the end as the key risks will not fully materialise. That will allow markets to return to risk-on mode before the end of the year after a rocky summer now. Unfortunately, each crisis such as the current turmoil in Turkey adds to the risk that the wobbly patch for markets and the Eurozone economy may last a little longer.

Since February, a series of political crises and external shocks has battered the Eurozone and its markets, notably the trade tensions stoked by US President Donald Trump, the formation of a radical government in Italy, an unexpected change in government in Spain, a brief German political crisis in late June and early July, some foreign policy crises (North Korea, Iran), concerns about China and now the turmoil engulfing Turkey. As a result, Eurozone growth has slowed down from a unusually fast 2.5% pace last year to average annualised gains of c1.5% in the first half of this year, in line with our estimate of trend growth. While the euro remains strong on a trade-weighted basis, it has – contrary to our initial forecasts – lost ground to the safe haven currencies USD and CHF.

Key surveys suggest that the worst could be over soon. After significant declines from February to April as trade tensions erupted, the European Commission’s broad economic sentiment index, the Eurozone composite output purchasing managers’ index and Germany’s Ifo business climate have slipped only slightly from May onwards. Although trade tensions between the US and the EU peaked in June and July, the near-stability in these surveys indicates that businesses are getting used to the noise. In the absence of new shocks, the underlying fundamentals should re-assert themselves in Q4 2018, allowing markets to largely reverse the setbacks suffered so far this year.

On its own, the turmoil in next-door Turkey poses no major challenge for the big Eurozone. Even a drop in Eurozone exports to Turkey by 20% would not subtract more than 0.1ppt from Eurozone growth. As usual, financial linkages are potentially more significant. Individual institutions may well be affected to a significant degree. Still, the risk that the exposure of some Spanish, Italian and French banks to Turkey could turn into a systemic problem for the Eurozone and/or cause a tightening of credit conditions in Spain, Italy or France remains remote.

The real risk stems from the level of noise. Confidence and hence the readiness to spend and invest often drives the business cycle. For our base case, we assume that, in the absence of dramatic damage from any of the crises that are making headlines, business confidence and market sentiment will rebound somewhat later this year. However, as confidence is currently fickle with no established trend, even smaller but highly visible problems can nourish the feeling that the world is a dangerous place rather than a market full of exciting opportunities. Hence the risk that any noisy crisis such as the Turkish turmoil could take some toll on the Eurozone and retard the upturn in markets and business sentiment for a while.

PROGRESS REPORT
Before we focus solely on the risks, remember that, on many key issues, we are largely on track for a more benign end to the year.

• The risk of a genuine trade war between the US and the EU has receded for now thanks to the Juncker-Trump armistice agreement of 25 July.

• As Italy’s radical government has started to seriously discuss the parameters for its 2019 budget, the positions of 5Stars and Lega are becoming less unrealistic. Of course, they are still far away from a budget deal that would respect Italy’s constitutional requirements for fiscal prudence and its obligations under EU fiscal rules.

• Germany’s political “crisis” has evaporated although the underlying issue – a dispute about migration – has not yet been fully resolved.

• Spain’s new government, with just 84 of 350 seats in parliament, may not get much done beyond easing tensions with Catalonia somewhat. Still, as Spain fixed most of its urgent economic problems under the previous government, a period without major policy changes would leave Spain’s solid growth momentum intact.

• As decision time approaches, the domestic Brexit debate in the UK has heated up, accentuating the tail probabilities of a “no deal” hard Brexit and of a second referendum. However, amid all the noise, the official British position on outlines for a post-Brexit relationship with the EU27 has softened to such an extent that, for the first time, the EU can now take the British position as a basis for serious negotiations.

A COCKTAIL OF RISKS
Beyond a noisy slump in Turkey that may force the country to call in the IMF for help, other risks could make headlines in the next few months:

• A potential escalation of the US-Chinese trade war could overshadow the current truce in US-EU trade relations.

• Italy’s fiscal debate could spook markets next month as the radicals in power need to set the key parameters for the 2019 budget by 30 September.

• Brexit issues will likely come to a head noisily at and shortly after the Tory party conference 30 September – 3 October.

Of course, surprises may also come from unexpected quarters, as they often do.

THE BASE CASE
For our base case, we assume that
• the US and China will sit down for serious negotiations and thus defuse their tensions somewhat ahead of the US mid-term elections on 6 November, perhaps with Trump again wanting to claim that he brokered a successful “deal”,

• Italy’s budget deficit for 2019, while breaching European commitments to reduce the structural deficit over time, will remain close to the likely 2.4% outcome for 2018 and not approach or surpass the Maastricht threshold of 3% of GDP,

• In the end, the UK will accept a version of a semi-soft Brexit which the EU 27 can offer, with UK Prime Minister Theresa May probably needing some opposition votes to get the deal through parliament;

• Turkey does not trigger such a devastating series of crises in other emerging markets (Russia, Latin America, etc.) that the combined impact could dent growth in the developed world in a meaningful way although each of these crises would have only a marginal impact on Europe, the US and Japan on its own.

Under these assumptions, businesses and investors will likely get used to the somewhat elevated level of noise. The mostly positive economic fundamentals will re-assert themselves in the end. That would allow a return to a more risk-friendly market environment in Q4 this year after a rocky summer. Of course, these assumptions also highlight the risk to our economic and financial calls. With another crisis (Turkey) just springing up and key decisions on trade, Brexit, Italy etc. ahead, we need to watch whether the likely return to above-trend growth in the Eurozone and better market sentiment could be delayed yet again.

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