When PIMCO professionals gather for our annual Secular Forum to discuss the long-term global economic outlook, views on Europe invariably gravitate on two themes: anemic GDP growth and political risk. However, recent developments are challenging these views. The eurozone’s economic expansion is entering its fifth consecutive year, and voters recently shunned populist parties at general elections in Austria, the Netherlands and France in favour of pro-European ones. The temptation is to conclude Europe’s outlook is much better than its reputation.
Near-term (cyclical) eurozone forecast generally positive
Cyclically, we concur. With the output gap narrowing and unemployment falling in the eurozone as a whole, we expect the European Central Bank (ECB) to continue to grow its balance sheet in 2018 but to taper the pace of its monthly purchases, taking into account the improving growth and inflation prospects.
Three countries are especially likely to influence Europe’s growth forecast:
- The election of President Emmanuel Macron should give France an opportunity to enact a comprehensive package of reforms aimed at making its labour, goods and services markets more dynamic as well as addressing the country’s rising debt burden.
- While ruling out eurobonds in their election manifesto, Germany’s leading parties support developing – together with the French government – the eurozone’s own monetary fund along with strengthening pan-European defense, border and immigration controls.
- These signs of solidarity are not going unnoticed in Italy, where populist parties now appear less adamant for Italy to leave the euro.
That said, the bar to exceed expectations in the eurozone is rather low.
Fiscal and monetary policy: two long-term challenges to Europe’s economic growth
Since the global financial crisis, eurozone GDP growth has lagged other regions of the world, including that of its neighbours. Between 2008 and 2016, real economic output in the eurozone expanded a cumulative 2.9%, compared with 4.4% in Denmark, 9.6% in the UK, 10% in Switzerland, 14.8% in Sweden and 26.8% in Poland (source: Eurostat). The latter countries pursued centralised fiscal policies and, except Denmark, floating or managed exchange rates – leading to one hypothesis that the eurozone’s lackluster growth is attributable not to its composition of member states but to its structure of fixed exchange rates and decentralised, regional fiscal policy. Changing the eurozone’s governance structure (by establishing a common budget, for example) requires Treaty change, for which there is little appetite. In addition, the European Stability Mechanism remains too small to help a large member state threatened by loss of market access. Building stronger fiscal structures that could better buttress the eurozone economy against the next downturn poses the first long-term challenge.
The second challenge ahead of the next recession (whenever it occurs) is to fortify the monetary policy arsenal. In our baseline secular outlook, we expect the ECB to raise the deposit facility rate to zero in 2019 (which coincides with the end of President Mario Draghi’s term) and reduce its balance sheet from 2020 onward. Were growth in the U.S. to continue uninterrupted until then, the current economic expansion would become the longest on record. Longevity alone does not kill an expansion, but it increases the probability of recession – and by the time the next recession inevitably arrives, the ECB will ostensibly have little policy ammunition to deal with it. The policy rate’s proximity to zero and technical constraints limiting the size of ECB’s balance sheet make the central bank a less reliable backstop to a disinflationary shock.
PIMCO’s long-term economic forecast for Europe and investment implications
Under our baseline outlook, eurozone GDP growth averages 1.25% annually over the next three to five years with headline inflation hovering between 1% and 2%. We see bullish and bearish risks to the outlook as roughly balanced in the near term, but increasing and tilting to the downside toward the end of our secular horizon.
We believe the most acute risk for the eurozone over the next five years is a market crisis driven by fears of a country exiting the single currency. It is highly unlikely that Italy will leave the euro, even though the country’s economic growth and support for the single currency are among the lowest of the currency zone’s 19 member states. But the odds of a crisis brought about by markets pricing in that slight risk of redenomination – perhaps triggered by a victory of the Five Star Movement in next year’s general election – are not minuscule. For the ECB, higher risk premia associated with even latent redenomination risk would tighten financial conditions and blunt the transmission of monetary policy evenly across the eurozone.
Less ECB support is a source of upside risk for government and peripheral bond yields. We expect to be cautious on eurozone peripheral risk in the period ahead as the ECB weans the economy of its ultra-accommodative support.
Learn more about the Secular Forum, where PIMCO investment professionals gather to debate and determine our three- to five-year outlook for the global economy and markets, and read our in-depth secular views and investment implications.
Andrew Bosomworth is PIMCO’s head of portfolio management in Germany and a regular contributor to the PIMCO Blog.