Still a rather positive outlook

In a nutshell

• The trade dispute has weighed on headline Eurozone growth this year, owing to the very open nature of its economy.
• Domestic indicators nonetheless remain very solid, even suggesting that the inflation outlook may finally be changing – and with it the ECB's policy stance.
• The just released Italian budget promises further tensions with Brussels, hence continued market volatility.

Eurozone economic growth has slowed this year but is still broad-based, with all countries participating in the upturn, and firmly above potential. Lesser external demand accounts for much of the slowdown – the Eurozone being more open than most other large advanced economies (see chart VI). Domestic indicators remain robust: employment and real income are trending up and lending growth to non-financial corporates has accelerated.
 

A tighter labour market also means rising wage pressures (see chart VII). With the unemployment rate now approaching the NAIRU (Non-Accelerating Inflation Rate of Unemployment) threshold, shortages are becoming visible in Germany, the Netherlands and even France, where the share of firms citing the lack of workers as a constraint on production has almost doubled over the past year. For the Eurozone at large, nominal hourly wages posted 2.2% year-on-year growth in the 2nd quarter, their fastest pace since the 4th quarter of 2012.

Given the positive correlation between wage growth and the core consumer price index, the inflation outlook may finally be changing in the Eurozone. Of note also is the fact that, according to a European Commission survey, consumer inflation expectations have now reached their highest level since 2013.

In turn, the pickup in underlying inflation pressures lessens the case for massive monetary stimulus. The ECB appears set to end its asset purchases this year and we expect the negative interest rate policy to be abandoned in late 2019.

On the political front, Italy is obviously the main issue right now. The just presented budget involves a 2.4% deficit, well above the previously discussed 1.6% level (not to mention the 0.8% targeted by the prior government). It would appear that the more populist members of government had their way. And with the plan focused on domestic demand, rather than productive investment, tensions with Brussels are likely to intensify – as might the risk of a debt rating downgrade. So, although Italy's significant current account surplus and mostly domestically held public debt suggest no solvency risk, additional volatility can be expected in the coming weeks.

​