investment insights
Europe’s upturn is here but structural issues remain
Key takeaways:
- Europe’s economy is growing, with its GDP growth rate matching the US’s, record-low unemployment and normalising inflation paving the way for higher consumer spending and improving financial conditions
- We expect the ECB to cut rates three times in 2024 with further easing at a faster pace next year to take the central bank’s deposit rate to a terminal level of 1.5%
- Ahead of European Parliamentary elections, structural issues persist, including underinvestment, with Germany facing weak manufacturing and internal political challenges
- We are overweight euro area sovereign debt to take advantage of high yields and expect more pressure on the common currency. We keep our allocation to European equities at underweight levels.
So far so good. After two years of stagnation, Europe’s economic developments in 2024 are proving positive. Growth is rising, unemployment has fallen to a record low, and normalising inflation means that the European Central Bank (ECB) is ready to start cutting interest rates.
In the first quarter of 2024, euro area Gross Domestic Product (GDP) grew at an annualised rate of 1.3%. This was exactly the same growth rate seen in the US, coming after a long period of European underperformance. It is also a much better growth than Europe’s previous quarters, with the slight contraction recorded in late-2023. Higher frequency indicators such as Purchasing Managers’ Index (PMI) surveys have continued to improve into the second quarter, suggesting that European growth has further room to rise.
We believe this changing trend is supported by improving economic fundamentals. Most importantly, as discussed at the start of the year, real household incomes are finally improving across the euro area, thanks to increases in employment, robust wage growth, and falling inflation. These trends coincide with improving consumer confidence, suggesting that after a long period of high saving rates, European consumers may now turn more willing to spend.
In addition, while financial conditions are certainly restrictive in the euro area, their peak effect is probably several months behind us. Lending to the real economy has started to pick up again. Rate cuts by the ECB -which we think will be more extended than market expectations - are likely to improve credit conditions further. The combination of improved spending power, rebuilding confidence, and easier financial conditions bodes well for near-term growth prospects after the deep shocks of the past few years.
As a result, markets have consistently increased their growth expectations in recent months. Our GDP forecast of 1.1% growth in 2024 no longer looks particularly high compared with consensus, which has moved closer to our view. We expect growth to accelerate further into next year, with economic expansion in 2025 likely to exceed 1.5%.
ECB rate-cutting cycle gets underway
Sharp disinflation over the past year-and-a-half has brought headline inflation down from its double-digit peak in late-2022 to today’s mid-2% range, putting the ECB’s policymakers in a more comfortable position. Based on the ECB’s March macroeconomic projections, inflation looks set to fall below 2% by mid-2025, and stay below-target for the rest of its forecast horizon. As a result, an ECB rate cut on 6 June looks all but certain. Several of the central bank’s officials have offered guidance - in some cases effectively pre-announcing a cut.
This week’s monetary policy meeting will also be important in other ways. While the start of the cutting cycle matters, the subsequent pace of easing matters even more for markets. Currently, interest rate futures pricing indicates a scenario of only two 25 basis point (bps) cuts, possibly reflecting concern with signs of stickiness in services inflation. But with no signs of a wage-price spiral, well-anchored inflation expectations, normalising wage growth, and still-anaemic domestic demand, we think that inflation persistence concerns in the euro area are exaggerated.
We believe that the ECB will ease at least three times this year, and then make back-to-back rate cuts in 2025. Market expectations point to a terminal rate above 2.5% for the cycle, which we see as about 100 bps too high. With few signs of an investment boom or widening fiscal deficits in Europe, we find a scenario of sharply higher equilibrium interest rates unlikely. In fact, structural questions about low potential growth given disappointing productivity and Europe’s demographics may well come back to the fore when the current cyclical upturn is over. We therefore think there is room for financial conditions to ease meaningfully, providing a positive surprise compared with market expectations.
Structural challenges remain
While the much-needed cyclical upswing has finally arrived, key long-term challenges remain. Recent growth surprises were primarily driven by net exports, with most domestic demand components still relatively weak. Crucially, investment is still below its 2019 level, raising questions about the durability of the growth upturn. The spillover from geopolitical risks, including higher energy prices and increased tariff barriers, can have a negative impact on European growth, as has happened in past episodes. And demographic ageing poses structural limits to the economy’s potential growth.
Germany in particular faces significant challenges. Growth has underperformed the rest of the euro area. The manufacturing sector is particularly weak, given the impact of the energy shock and German industry’s high exposure to China. In addition, the country’s three-party governing coalition is constrained by its internal dynamics, including a constitutionally-tight fiscal stance and the under-investment of recent years in infrastructure, all of which constrain potential growth.
‘Next Generation’ EU funds have helped the European recovery, especially in peripheral economies. But with fund disbursements set to peak this year, and end by 2026, the impulse to growth may diminish. Early hopes that successful implementation could make the recovery fund a permanent feature of the EU’s financial architecture have been disappointed as initial discussions made little progress. While common debt issuance at an EU level was a substantial breakthrough, and provided financial markets with a much-needed safe asset, there is strong resistance from core countries against repeating the idea. Similarly, the goals of a banking and capital markets union across the bloc remain elusive.
EU elections
European Parliamentary elections, held 6-9 June, will focus on the rise of hard-right parties across the continent who are expected to see an increase in their share of the vote, according to opinion polls. Based on current projections, the centre-right European People’s Party (EPP) group looks likely to maintain the biggest share of seats. Together with the centre-left Socialists and Democrats (S&D), and Renew Europe (RE), the EPP will probably command a centrist pro-European majority in the European Parliament. The right-wing may attract about one-fourth of the total vote, but with their seats split between party groups (the ‘European Conservatives and Reformists’ or ECR and ‘Identity and Democracy’ or ID), who do not always share an agenda, their effective policy influence may prove more limited. We expect little material impact on policy spending. The European Parliament alone does not determine EU policy, with the European Council (representing EU governments) playing a critical role in most policy areas. But with right-wing parties less supportive of economic integration, the result of these elections could add to the challenges around topics such as the capital market union. Meanwhile the likely losses faced by Green parties may result in less support for the EU’s green agenda.
Following the EU elections, according to convention, the winning party’s candidate for European Commission President is proposed to the Parliament for a vote. Although this process is not always followed, it suggests a high probability that Ursula von der Leyen (the EPP’s candidate) will be re-appointed for a second term at the European Commission. The key variable will be the combined number of seats earned by the three centrist parties (EPP, S&D, and RE), and the negotiating dynamics between parties. Given the amount of work that awaits them, a swift decision and a clear agenda for the top EU jobs will be critical.
We overweight euro area sovereign debt in our portfolios and continue to believe that at these yields it is time for investors to lock-in high rates before the rate-cutting cycle begins. In currencies, we expect the euro to come under pressure as markets shift focus to the ECB’s rate cuts. For global investors cheered by rising earnings expectations in the EU, the prospect of looser lending conditions for European firms offer another potential boost. However, investors also need to keep an eye on the rest of the world, including China’s economy, where many of Europe’s corporations make a large share of their revenues. For now, we keep European equities at underweight levels, given the challenges faced by some key sectors, and more attractive earnings growth elsewhere.
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