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Is the eurozone really heading into recession?

The slowdown across the eurozone is centred on manufacturing and exports but domestic conditions are holding up reasonably well.

The crisis countries are doing better and German fiscal expansion may finally come, writes Stefan Gerlach, chief economist at EFG Bank.

The ongoing tariff war between the US and China has adversely affected European (particularly German) exports to China, with the auto sector notably affected.

Geopolitical tensions in the Gulf region and continued uncertainty about Brexit have compounded the problems.

Nevertheless, survey indicators, such as the composite Purchasing Managers’ Index (PMI), which takes into account the more buoyant service sector as well as the manufacturing sector, suggest that the eurozone economy will see low growth rather than an outright recession (see graph). 

And there are some bright spots: consumer confidence has held up quite well; and the former crisis countries – Spain and Portugal in particular – have fared much better than the ‘core’ economies recently.

Escaping the doom loop

In Italy, after concern about the direction of the former populist coalition unsettled financial markets, the formation of a new pro-European coalition has seen a marked rise in bond prices and drop in bond yields.

If sustained, these much lower yields will mean that financing the government’s debt becomes cheaper.

That will bring a reduction in Italy’s fiscal deficit, which in turn will generate some flexibility for fiscal easing in the future.

That benign interaction will, if handled appropriately, also help to strengthen bank balance sheets.

Instead of the doom loop of the eurozone crisis, when bank and government finances deteriorated together, both could improve simultaneously.

Easier policy

However, it is other eurozone countries that have the greatest degree of flexibility on fiscal policy as the graph below shows.

In Germany, notably, with a government budget surplus and debt below the 60% Maastricht limit, it seems that attitudes are already becoming more accepting of greater government spending.

In particular, this looks set to be focused on environmental projects.

In the important sense that this relieves pressure on monetary policy to support growth it will be welcome, not least by the ECB.

Nevertheless, with the eurozone facing long-run demographic challenges (not dissimilar to those seen in Japan) and continued very low inflation, the challenges faced by the region remain very real.

This article was written for Expert Investor by Stefan Gerlach, chief economist at EFG Bank. 

Part of the Bonhill Group.