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European elections in an era of economic and political disruption

The stakes are high for elections to the European Parliament in May: they will test populist strength across the bloc at a time when economic momentum is weak. In this edition of Ahead of the Curve, we examine how this dynamic could steer the agenda in the weeks before the vote.

Key points

  • The eurozone economy slowed sharply in H2 2018 and started 2019 on a weak footing. However, growth should stabilise at lower rates going forward. We forecast growth of about 1% for 2019, down from 1.8% in 2018 and 2.4% in 2017.
  • Some positive external factors should help, including more accommodative monetary policies globally, China’s stimulus and receding concerns about a US-China trade war.
  • Importantly, domestic factors should also be supportive this year, most notably a solid labour market and an expansionary fiscal policy.
  • Nonetheless, risks to our baseline view remain skewed to the downside, mainly due to policy and political uncertainty (both domestically and externally).
  • The bloc looks vulnerable as it lacks the tools to deal with the next crisis. The response to the next downturn must come from fiscal policy. However, insufficient progress has been made to create a eurozone budget. 
  • Upcoming European elections are likely to show a significant gain for populist parties. While mainstream political forces are likely to maintain a majority in Parliament, populists may disrupt the functioning of European institutions from within, hindering the already challenging process of integration.

Economic weakness in Europe

So far this year, the weakness in economic data has persisted in the eurozone even though major developed central banks have shifted to more accommodative monetary policies globally and China’s economy has showed early signs of stabilisation.

It is still too early to tell whether we are witnessing a temporary soft patch or a more protracted and pronounced downturn in the eurozone. But our expectation is that the eurozone economy will stabilise at lower growth rates of 0.2%-0.3% quarter-on-quarter for the balance of the year. In annual terms, we expect growth of about 1% for 2019, down from 1.8% in 2018 and 2.4% in 2017.

Although some positive external and domestic factors should prevent further deterioration in growth, the balance of risks to our baseline forecast is skewed to the downside amid policy and political uncertainty.

Last year, growth was impeded by temporary and persistent factors. In H2 2018, temporary drags on growth included European Union (EU)-wide new vehicle-emissions rules, low water levels in the river Rhine (which disrupted internal transportation in Germany) and the Yellow Vest protests in France. These temporary obstacles have largely dissipated, which should have a positive impact on growth this year.

However, more fundamental drags on growth have continued in recent months. Net trade made a negative contribution to growth in H2 2018 (see chart 1), and external demand has remained soft in early 2019, with only tentative indications of stabilisation in China. And while risks of a trade war between the US and China have receded, trade-policy uncertainty has persisted.

Chart 1. Net trade contributed to the sharp European slowdown in H2 2018

Eurozone GDP growth, year-on-year and contributions by expenditure components

Source: Reuters DataStream, based on Eurostat data, as of April 2019.

The manufacturing sector – an industry that is more sensitive to the evolution of external demand and cyclical development – has been at the epicentre of the eurozone slowdown.

In H2 2018, the eurozone’s manufacturing sector entered a technical recession, as industrial production contracted for two consecutive quarters (-0.1% quarter-on-quarter in Q3 and -1.2% quarter-on-quarter in Q4) (see chart 2).

In January, industrial production bounced back by 1.9% month-on-month, and it was little changed in February – its January-February average is 0.8% higher compared to Q4 2018 – but economic surveys have remained on a downward trend, raising doubts about the sustainability of the rebound. Most notably, the manufacturing Purchasing Managers’ Index (PMI) slipped into contractionary territory in February and in March, touching 47.5 (its lowest level in almost six years).

Chart 2. Manufacturing activity in the eurozone remains on a downward trend

Source: Reuters DataStream, based on Eurostat and European Commission data, as of April 2019.

Outlook pendulum: swinging between optimism and pessimism

Amid the negatives, there are reasons to suggest that eurozone growth may stabilise in the middle of this year.

There have been some positive external developments:

  • Monetary policies have become more accommodative across the globe, following the US Federal Reserve’s (Fed’s) dovish pivot in early 2019. As the US dollar is the world’s reserve currency, the Fed’s monetary policy tends to have spill-over effects for the rest of the world. In January, it announced a pause in its hiking cycle, adopting a strategy of patience and data-dependency. In March, the Fed updated its dot plot, showing no rate hikes in 2019 (down from two in December) and announced plans to end its process of balance-sheet normalisation in September this year (implying the balance sheet will stabilise at about $3.75tn, a level much higher than envisaged by Fed officials only a year ago). Other major central banks followed suit, adopting a more dovish approach in recent months.
  • China has employed monetary and fiscal stimulus since mid-2018. However, it has been more limited and targeted than before. As a result, external spill-overs are likely to be more contained. In particular, China’s fiscal stimulus has targeted domestic demand by including a set of significant tax cuts worth 2tn yuan (about 2% of China’s GDP). However, implementation issues and the distribution of tax cuts (they mainly benefit high incomes) imply that the impact on growth may be limited to about 0.5 percentage points (pp) of GDP.
  • Concerns about protectionism have receded as a US-China trade deal appears to be within reach.

Importantly, some domestic developments should also provide support:

  • The labour market has continued to improve, which should continue to underpin consumption. Since 2013, the economy has added 10m jobs, while wage inflation has increased to 2.5% recently from a low of 1% in 2014-2016 (see chart 3).
  • Eurozone fiscal policy has turned expansionary in 2019 from neutral last year. The cyclically adjusted primary deficit should widen by about 0.5pp of GDP in 2019 in the eurozone in aggregate, reflecting similar moves across the main countries in the bloc. Fiscal expansion results from idiosyncratic country-level developments rather than cross-country coordination, which could result in diminished effectiveness. For this reason, we expect an increase in growth this year of 0.2-0.3pp of GDP.

In addition, policy uncertainty has receded. But at a domestic and external level, it has not been resolved. Although a US-China trade agreement looks increasingly within reach, a deal has not yet been secured. Protectionist tendencies are still certainly in play and there is a risk that trade tensions between the US and the EU could escalate, particularly on auto trade.

Domestically, the political landscape is still mired with uncertainty amid Brexit, European elections and a possible bout of political instability in Italy by the end of the year.

Fundamentally, the eurozone slowdown also reflects convergence towards a weak trend rate of economic growth, reflecting both poor prospects for productivity growth and challenging demographics. From this perspective, growth of 2% or more was unsustainable, and probably driven by special factors (i.e. extraordinarily strong external demand) in 2017 and 2018.

In the last decade, the bloc’s productivity growth averaged 0.8% compared to 0.6% in the last three years. Productivity performance is sluggish across major countries in the bloc – and it is particularly poor in Italy (see chart 4).

Furthermore, the demographic profile in Europe is quite negative. The UN projects that the population will grow by 0.3%-0.2% annually in the coming years – and an aging population implies that the working-age population will actually contract slightly.

Chart 3. Eurozone employment and wage inflation have picked up in recent years, supporting consumption

Source: Reuters DataStream, based on Eurostat data, as of April 2019

Chart 4. Productivity growth has been poor in major EU countries

Productivity growth per hour worked, three-year moving average (year-on-year)

Source: Reuters DataStream, based on Eurostat, as of April 2019.

The eurozone's key players

The German economy – the engine room of the eurozone – has been spluttering of late. In H2 2018, it narrowly avoided a recession, but the nation’s powerhouse manufacturing sector did not: industrial production contracted sharply for two consecutive quarters in Q3 and Q4. So far in 2019, economic data has been mixed, but a combination of external and domestic factors – as previously discussed – should help the economy stabilise in the middle of the year. We forecast GDP growth of about 0.8% in 2019, down from 1.5% in 2018.

China’s cyclical slowdown and the regulation-driven disruptions to the auto sector have exposed the vulnerability of the German growth model: it is over-reliant on the export sector (see chart 5), while domestic demand is sluggish.

Indeed, in its current state it operates a two-speed economy, comprising a highly productive export-oriented manufacturing sector and a lagging services sector.

Going forward, the German growth model will come increasingly under pressure. That’s because:

  •  A structural slowdown is expected to gradually continue in China as the economy transitions to a more mature growth model;
  • The auto sector is undergoing a profound period of change and this is expected to continue as the transition to a low-carbon economy requires a more sustainable transportation model;
  • Public investment has been weak, reflecting a general aversion to public spending. The German fiscal stance was restrictive in 2018, resulting in a fiscal surplus of 1.7% of GDP. Indeed, the fiscal easing forecast in 2019 (worth about 0.5pp of GDP) would be a reversal of tightening that occurred in the previous year. The slow change in the country’s fiscal stance also reflects the lack of political momentum: it took five months for the country to form a coalition government after a general election in September 2017; and
  • Chancellor Angela Merkel has become a lame-duck leader. She is no longer the head of the centre-right Christian Democratic Union (CDU) after stepping down in December last year and she will not run in the next election. Her diminished political influence implies an even more pronounced fragility of the current coalition government. The next election is scheduled for October 2021, but all things considered, a snap election could be called before then.

 Chart 5. German exports as a share of GDP have doubled in the last three decades

Source: Reuters DataStream, based on data from the International Monetary Fund and Germany’s Federal Statistical Office, as at April 2018.

Economic growth has held up in France, albeit at sluggish rates. That said, it has outperformed Germany in recent quarters and we expect this will continue in 2019, with French annual GDP growth tracking at about 1.1% (compared to 1.5% in 2018).

French President Emmanuel Macron has made concessions to the Yellow Vest protesters, which will take the country’s fiscal deficit beyond the EU’s Stability and Growth Pact limit to 3.4% this year. However, this fiscal expansion should only provide a modest boost to growth (about 0.1pp of GDP).

What’s more, structural reforms are needed, but it is unclear whether the Macron administration has the political capital to implement them. A decent result at the European elections would bolster the government. For now, however, polls show that Macron’s La Republique En Marche party is only slightly ahead of the far-right Rassemblement National party, led by Marine Le Pen.

In H2 2018, Italy slipped into a technical recession as the economy contracted slightly for two successive quarters (-0.1% quarter-on-quarter in both Q3 and Q4) (see chart 6). Early indications for Q1 point to a soft start to the year: preliminary readings for Italy’s composite PMI showed that the economy was in contractionary territory in January and February, before bouncing above 50 – the level that separates contraction and expansion – in March. Indeed, the country’s manufacturing sector has been particularly affected due to its reliance on external demand and its deep integration in regional supply chains.

Separately, the increase in Italian long-term sovereign bond yields has resulted in some limited tightening of credit conditions, which is not helpful. However, fiscal stimulus should provide a boost in H2 2019 – but the effectiveness of the government’s flagship measures is doubtful.

In 2019, the Italian economy will probably stagnate, as suggested by forecasts from international institutions (the OECD predicts it will contact by 0.2%) and the Italian Finance Ministry (the latest update of the stability program shows a 2019 growth forecast of 0.1%).

In addition, domestic political dynamics are a potential source of downside risk. Indeed, the country risks another bout of significant political instability sometime this year – and if the European elections do not trigger a government crisis and new national elections, the budget discussions at the end of the year – likely to be highly controversial – probably will.

Chart 6. Italy slipped into a technical recession in H2 2018; further weakness is expected this year

Source: Reuters DataStream, based on ISTAT and the European Commission data, as at April 2019.

The eurozone’s fourth-largest economy emerged from a deep economic slump in 2013. Since then, the Spanish economy has experienced a strong recovery. Last year, the economy expanded by 2.6%, but growth will probably slow to about 2% in 2019 – still well above the eurozone average.

The nation has been plagued by political instability – and this is likely to persist in 2019. In February, the Spanish parliament rejected the 2019 budget after Catalan separatists turned their back on the government. Subsequently, a snap election was called by the centre-left government, which will take place on 28 April. The election is likely to produce a hung parliament and a weak minority government, again.

The eurozone needs a common fiscal framework

Given the fragility of the eurozone economy, it is natural to think about the policy response to the next serious economic downturn or recession.

In the wake of the 2008 global financial crisis and the subsequent sovereign debt crisis, the ECB had to do all the heavy lifting, resorting to unconventional measures. It brought the deposit rate into negative territory in mid-2014 and started an asset-purchasing programme at the end of 2014.

Presently, it looks like the ECB has reached its limits, despite reassurances that its toolbox is still plentiful. Both negative rates and quantitative easing (QE) have significant drawbacks. There are limits to how low negative rates can go and they have a negative impact on bank profitability, which could impair the transmission mechanism of monetary policy in a context where credit provisions typically go through banks.

At the same time, it looks like QE is affected by the law of diminishing marginal returns: successive rounds of QE (in the US and elsewhere) had a weaker impact on financial markets and the real economy. And for the ECB, QE has probably hit its political constraints.

In other words, there is only one credible response to the next downturn – and it must come from fiscal policy, especially in a context where shocks are usually asymmetric across countries (another limit of monetary policy is its one-size-fits-all feature). Alas, there is no common fiscal framework in the eurozone to respond to such situations.

A common fiscal framework is necessary to complete and underpin the monetary union, but it will not be easy to achieve as different countries have different fiscal spaces. And the availability of fiscal transfers within the union poses moral-hazard issues.

The debate about the eurozone budget has been ongoing at least since the eurozone debt crisis, and it has gained further traction in recent years. However, recent progress has been limited. After a long and uninspiring tug of war between Germany and France, the two countries agreed to the concept of a small budget in June 20181.

Last December, eurozone leaders agreed to create a eurozone budget as an instrument for convergence and competitiveness of the bloc. However, its size and structure will be determined within the constraints of the wider EU Multiannual Financial Framework (MFF)2.

While the features of such a budget should be agreed by June, a delay to its implementation looks likely.

Indeed, the debate has quietened recently, at least publicly3. Other issues, such as migration, have dominated the agenda and, more importantly, European elections are approaching, which has shifted the focus to campaigning and preparing the ground to decide who will occupy the EU’s top positions.

But there are some known obstacles: the European Council and the current European Parliament are struggling to agree on the MFF. Any delay to the MFF has a knock-on effect on the eurozone budget. For now, it looks unlikely that the net MFF will be approved before summer – and what’s more, the modalities of funding are controversial.

The impact of the European elections 

As mentioned, Europe has been no stranger to the trend of rising populism. For example, the anti-establishment Five Star Movement and the right-wing League formed a coalition government in Italy in June 2018, while the far-right Alternative for Germany party made its debut in the German Parliament following the 2017 election.

Indeed, the last two recessions in Europe occurred in quick succession and were followed by slow and uneven recoveries. Undoubtedly, these economic conditions have taken their toll on the reputation of the EU project – in particular concerning its ability to deliver prosperity.

In addition, the fact that national governments have tended to blame European institutions for domestic issues has not helped.

These factors, together with the fact that European elections traditionally attract the protest vote, suggest that populist parties are likely to enjoy significant advances in the elections next month.

A recent analysis by JPMorgan (see Chart 7), which is based on national polls, shows that if the European populists joined forces they would form the largest parliamentary group, with 191 seats in the 705-seat European Parliament. That compares to 140 seats in the 2014 European Parliamentary elections (all figures exclude UK parties).

Chart 7. Polls suggest populist parties will gain 50 more seats than in the 2014 European Parliamentary elections

Source: JPMorgan as at March 20194.

However, European populists are characterised by a high degree of fragmentation. National populist parties are spread across most of the nine European parliamentary groupings, including the largely mainstream European Popular Party. Importantly, while they all agree on the principle of repatriating sovereignty from the EU back to the nation state, they have no consistent views on other issues and policies.

Our bottom line is that the three mainstream parliamentary groups – the Popular Party, the Socialists & Democrats and the Liberals – will probably maintain control of the European Parliament. In turn, they will be able to decide the distribution of the EU top jobs. But they will need to cooperate.

Nonetheless, populist parties will probably gain enough power to disrupt decision-making processes, eroding the functioning of European institutions from within. In addition, mainstream parties may be tempted to pursue populist themes in an attempt to redeem support. These developments would hinder the already challenging process of integration, undermining the bloc's ability to combat the next downturn. 

The ability of the eurozone to tackle the next downturn or recession will depend on whether the next Parliament can advance the ongoing reform process and strengthen the EU project. In this respect, the elections on 23-26 May are crucial.

  1. 1See the Meseberg Declaration: https://www.diplomatie.gouv.fr/en/country-files/germany/events/article/europe-franco-german-declaration-19-06-18; published on 19 June 2018.
  2. 2See the Statement of the Euro Summit (point four) published on 14 December 2018 (https://www.consilium.europa.eu/en/press/press-releases/2018/12/14/statement-of-the-euro-summit-14-december-2018/).
  3. 3For more information the technical discussion on integration, see “Eurozone debate bubbles on” by Martin Sandbu published by the Financial Times on 8 March 2019.
  4. 4“Risk of surprises in the European Parliament elections”, by David Mackie published by JPMorgan on 8 March 2019.

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