Outlook for Europe Set to Challenge Policy Makers
Alan McQuaid
Alan McQuaid

Concerns about the health of the US and Chinese economies in particular, have impacted markets and forced a policy response from the respective authorities. The focus now is on the trade dispute, and whether or not a satisfactory agreement can be reached between the two super powers.

While the world economic outlook has clearly deteriorated in recent months, a key positive for financial markets has been the change in tune from the US central bank. Having hiked interest rates in December, the ninth 25bps (0.25%) increase in this tightening cycle, the Fed has now adopted a more dovish tone, given the worsening economic backdrop. Indeed, at its first meeting of 2019, it signalled its three-year-drive to tighten monetary policy may be at an end. As it held interest rates steady, the US central bank also discarded its promises of “further gradual increases”, and said it would be “patient” before making any further moves.

Meanwhile, there are legitimate grounds for unease regarding China. The world’s second-largest economy expanded last year in line with the official target, but overall growth was the slowest since 1990. Still, there is enough room for encouragement. Commodity producers, among the first to feel the pain if China stops building, have reported plenty of demand for copper, with physical inventories at record lows, and for high-quality steel ingredients. Beijing has already cut taxes and the amount of money banks need to hold in reserve, and has promised to do more to stimulate the economy, and avoid a hard landing.

But whatever about the US and China, the outlook for Europe in 2019 is the most challenging as policymakers confront a combination of slower economic expansion, potential disruption from Brexit, and a series of national and European Union (EU) parliamentary elections. Italy and the UK remain the two most significant risk concerns with Italy facing the biggest economic challenges in the year ahead due to the size of its public sector debt, fragile banking system and concerns over how its populist politics will influence investors. Germany is undergoing leadership change, while France is in the throes of a public backlash against longstanding grievances over heavy taxation, an out-of-touch political elite, immigration and socio-economic inequality. The European Central Bank (ECB) remains key to how the economic slowdown will be managed, which means that there will be considerable attention to who succeeds the institution’s head, Mario Draghi, in November of this year.

Although European unity will remain in place and recessionary threats are likely to be kept at bay, 2019 should see bigger pressures on EU institutions and demands for greater fiscal flexibility, which, in turn, could weaken sovereign credit ratings through larger fiscal deficits. The ECB remains an important factor. Considering that Eurozone growth is slowing and inflationary pressures are weak and show little sign of increasing in the next few months, the expectation now is that the central bank will leave interest rates at a record low this year, and that Draghi will depart office without having overseen a rate-hike during his eight-year term in office. If key economies in the bloc slow at a faster-than-expected pace (which is a possibility), the ECB may have to explore returning to some form of monetary accommodation. This will only put added pressure on to the shoulders of whoever replaces Draghi.

Probably one of the most difficult factors to gauge in terms of Europe’s economic outlook for the year is Brexit. While it is assumed that the UK will exit from its EU membership on 29th March, the unsettled nature of British politics has injected a considerable amount of uncertainty. A hard Brexit (the barest of agreements with the EU) or a no deal Brexit (no agreement in place) would have a dampening effect on European growth prospects. It would most likely translate into a deep recession in the UK. Germany, France, the Netherlands, Spain and Portugal would also feel the impact in everything from tourism to exports. Ireland is the most exposed, with the likelihood of a pronounced slowdown in growth.

Although the situation has yet to work its way out, and the prospect of the UK exiting the EU without a deal has increased, we still think that some type of agreement will be reached before year-end that avoids hurtling the UK and its major trading partners into an economic downdraft. At some point, the issue must be resolved and a desire for better days has to trump the current state of acrimonious division. Until then the UK will be a drag on regional economic growth.

But, despite the darkening clouds over Europe, a more market-friendly Federal Reserve should in the near-term offer the main support mechanism for risk-assets to continue their good start to 2019.

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