The euro area has shown no signs of improvement in recent weeks.
Industrial production fell by 3.3 percent year on year in November, its first decline since January 2017. The German economy only managed to expand by 1.5 percent in 2018, with a negative contribution from net trade. Sentiment indicators have continued to deteriorate, suggesting that growth will slow further in the near term, raising fears that the euro area could fall into recession.
While growth should remain unimpressive this year, complicating the European Central Bank’s ambition to raise rates for the first time since 2011, these fears look overdone.
The deterioration in the euro area’s trade balance was the main reason for the region’s disappointing performance in 2018. This reflected three factors. First, the rise in the oil price weighed on import prices and the terms of trade. Second, the relative strength of the domestic economy meant that imports grew at a decent pace. And third, export growth was weak, particularly compared to the second half of 2017.
The block’s total exports were affected by different regions. We can make three points.
First, Asia and EU countries (outside the euro area) were key sources of growth for euro area exporters in 2017, but accounted for little in 2018.
In Asia, the main swing factor was China, where the annual rate of export growth fell from 15-20 percent in 2017 to almost zero towards the end of 2018. This reflected both weak Chinese industrial activity and consumption, with car sales collapsing last year.
In Europe, export growth to the United Kingdom has been on a declining trend since the vote on Brexit in 2016, turning negative last year.
Second, exports to other emerging market economies such as Turkey and Russia weakened considerably.
Finally, the US economy was the main source of demand for euro area exports in 2018.
Leading indicators suggest that industrial production and the pace of export growth will remain weak in the near term.
Indeed, exports to the UK, which account for around 12 percent of total euro area exports, are likely to decline further given the uncertainty over Brexit.
While we think that the probability of a disorderly and chaotic exit from the EU is small, the direction of travel remains uncertain and will continue to weigh on the UK economy.
In addition, Chinese growth should slow further over the coming months and the sharp drop in Chinese car sales is likely to weigh on euro area exports for some more time. Finally, US demand should soften as the effects of the fiscal stimulus wear off.
Yet we think that fears of a euro area recession are overdone. Asian demand should rebound somewhat in the second half of the year as looser Chinese fiscal and monetary policy support the economy.
An extension of the US-China trade truce beyond the end of February, which we expect, should help European exporters too. Indeed, 10-15 percent of European exports to China are re-exported to the US.
Finally, while the weakness in the industrial sector is likely to affect the rest of the euro area economy, as already evident in confidence surveys, rising wages, a weaker oil price and accommodative financial conditions should provide a floor under domestic demand.
This will be a challenging environment for the ECB to raise rates. While we expect core inflation to pick up somewhat this year, it will be hard for the economy to generate much inflationary pressure if it grows around its trend-rate, as we expect.
At the last governing council meeting, ECB president Mario Draghi argued that risks to the outlook were still broadly balanced. It is hard to imagine that he will keep these words unchanged at the meeting this week.
With risks probably tilted to the downside, the ECB might have to keep rates unchanged for longer than it had anticipated only a few months ago.
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