Forecast Update: Fundamentals vs. Risks

Cyclical
. The drag from WLTP emission regulations on car production should be temporary. We see the cyclical fundamentals supporting ongoing moderately above-trend growth. Global growth expectations are fairly resilient. Despite higher inflation, real disposable income growth benefits from strong employment growth, rising wage inflation and an easier fiscal stance. Financial conditions remain easy and relatively stable. Credit conditions have improved, especially for households.

Structural. The economic cycle could be sustained for longer if trend growth were to improve. We think care needs to be taken not to over-estimate trend. First, reforms have been limited, both within and across countries. Second, the rise in participation rates lately may be only a temporary catch-up to the more modest pre-crisis trends. Third, Germany, the zone's largest member state, is on the verge of seeing the drag from ageing on a year-by-year basis. Assuming euro area trends in the 1.25-1.50% range, capacity constraints should remain binding, promoting investment spending on the one hand and sparking some pricing power and wage inflation on the other.

Risks. The primary concern is that the euro area has accumulated several sources of economic uncertainty over the last six months, including trade war, the policy choices of the new populist Italian government and talk of crash Brexit. The weakness of euro area capex orders and the recent rise in household fear of unemployment could be signs that the accumulating risks are affecting confidence and behaviour.

We include individual outlooks for the main European economies. The period ahead - Q4 2018 and 2019 - will still be intensely political even under our baseline assumptions that Italy adopts a less confrontational stance on fiscal policy and that crash Brexit is avoided. There is event risk and political equilibrium may be fragile. Macron's capacity to deliver his domestic reform agenda will in part be a function of his achievements with EU reforms, which are constrained by Merkel's limited room for manoeuvre in domestic politics. European Parliament elections next spring will be a litmus test for political stability. An early election in Italy is a risk, while Spain is probably on course for an election later in 2019. The latter will hope to continue differentiating itself from the former with a cooperative approach to Brussels and with the Catalan question only in the background. EU migration policy remains a key challenge.

If we are wrong and the risks materialise, Europe could slip onto a much weaker path as the loss of cyclical momentum exposes the underlying structural vulnerabilities. A substantive shock could trigger a chain reaction. First, the market might question the ECB's ability to lean against another large shock. Second, a growth shock could expose Italy's precarious public finances. Third, a further extension of low policy rates could impair banks' ability to support the recovery. Fourth, persistent weak growth could drive more voters to anti-EU populist parties.

We have shaved 0.1pp off our 2018 euro area GDP forecast, though we believe the macro outlook is essentially unchanged. Income growth (jobs and wages) remains solid and financial conditions easy. We assume the various risks from trade do not materialize in any substantive way. Several may linger, but peak uncertainty may be behind us for now, and we expect modestly above-trend but gradually slowing growth to continue into 2019.