Euro area: a middling recovery

The euro area's recovery is running out of steam. The weakening signs suggested by activity indicators in the last quarter have materialised with the euro area's economy standing still in Q2, putting an end to four quarters of growth at an average rate of 0.2% quarter-on-quarter. Although the breakdown in GDP by component has yet to be published, a drop in industrial confidence points to a decline in investment, halting the gradually improving trend in domestic demand. Exports have also been hindered by weak world trade at the start of the year and the escalation of geopolitical tensions, particularly in the Ukraine, is not helping either. To date, the figures available for Q3 show no clear signs of improvement: in August the economic sentiment index and PMI were below the Q2 average and consumer confidence has lost some of the ground gained in previous months. The scenario for the second half of the year is therefore not very encouraging. Although we expect the German economy to pick up slightly, growth in Europe's activity will be affected by the French and Italian economies as the most pessimistic predictions appear to be on target.

Progress is uneven. The trends in the four main economies of the euro area are highly disparate. Spain's GDP growth accelerated in Q2, increasing by 0.6% quarter-on-quarter (0.4% in Q1). This contrasts with the stagnation of the French economy for the second consecutive quarter and with the declines in GDP recorded in both Italy and Germany (0.2% quarter-on-quarter). In the German case, although its high GDP growth in Q1 (0.8% quarter-on-quarter) already suggested the economy would slow down slightly in Q2, such a slump in activity has come as an unpleasant surprise. Part of this greater deterioration is due to rising tension in the Ukrainian conflict. In this respect, although the country's relative weight of exports towards Russia is moderate (accounting for 3% of all sales abroad), uncertainty regarding the conflict's resolution and the effect this might have on the economies of Eastern Europe continues to damage German investor sentiment.

Growth in France and Italy is still unable to consolidate. The picture painted by the trends in Europe's other two large economies is not very favourable either. The main indicators available for Q3 confirm the weakness of the recovery. One symptom is the reduction in industrial confidence in July and August, now significantly below the average for Q2.
This context does not suggest there will be any upswing in investment which, in Q2, fell by 1.1% and 0.9% quarter-  on-quarter in France and Italy, respectively. Given this situation, the implementation of reforms to improve the poor competitiveness of both economies is still necessary to boost exports at times of need. Real French and Italian exports remained almost at a standstill in Q2 (with quarter-on-quarter variations of just 0.0% and 0.1%, respectively).

Private consumption loses steam in Q3. During the last few quarters, the recovery in household consumption has become an important support for growth in the euro area (accounting for almost one third of the GDP growth recorded between 2013 Q1 and 2014 Q1), a contribution that was still significant in Q2 judging by the good rate of growth enjoyed by retail sales (1.3% year-on-year in Q2 compared with 0.8% in Q1). However, the decline in consumer confidence in July and August suggests Q3 might see a slowdown.

The revival in activity is helping the labour market to recover, albeit very gradually. In July, the euro area's unemployment rate stood at 11.5%, 0.4 percentage points below the level recorded a year ago although there are notable differences between countries. Over the last few months the unemployment rate has particularly fallen in the periphery countries (down by 2.3, 1.7 and 1.6 p.p. in Portugal, Spain and Ireland, respectively). This improvement contrasts with the less dynamic labour market both in France and especially Italy, countries where unemployment has increased by 0.5 percentage points in the last year. The slight improvement in employment expectations of industrial and service companies in the first few months of Q3 point to this gradual recovery in Europe's labour market continuing. However, should the symptoms of economic weakness continue or get any worse employment expectations will also end up being affected.

Low inflation is putting pressure on the ECB. This context of weakness is reflected in the trend in prices, still at unacceptably low levels. In August inflation stood at 0.3%, 0.1 percentage points below its July figure although it should be noted that, in the last few months, the downward pressure has come mostly from the most volatile components while core CPI has remained stable at around 1%. In any case, this trend has significantly undermined inflation expectations
over the last month, something that has not gone unnoticed by the ECB President. In his speech made at the annual symposium in Jackson Hole, Mario Draghi was categorical in stating that this reduction in inflation expectations poses
an evident risk to price stability and the European authority appears to be more than ready to implement additional expansionary measures to ensure the institution's mandate is met. Rather surprisingly, Draghi also argued in favour
of reconsidering the role of fiscal policy in the euro area's economic recovery. The ECB's actions over the coming months will once again be crucial. It must continue to insist that additional measures will be taken in case the weak climate get sworse and should therefore offer more details regarding the work being carried out to reactivate the ABS market. The institution's communication policies (emphasising a commitment to price stability and the availability of tools that will be used if necessary) will be key to keeping inflation expectations anchored.

The foreign sector is finding it difficult to recover, both due to the slowdown in emerging countries and the upswing in sources of geopolitical tension. Given this situation, it comes as no surprise that, in the first half of the year, growth in European exports was modest (0.9% year-on-year). Although the outlook is more encouraging for the second half of the year, assisted by the revival in the main emerging economies and the euro's depreciation, the increase in downside risks, particularly related to geopolitical tensions, has reduced confidence in exports as a mainstay for the recovery.

The slowdown in activity shifts attention back to fiscal policy. This downward revision of growth prospects poses an additional challenge for the fiscal consolidation policies that European countries need to implement. For the moment, the message repeated by Mario Draghi, underlining the fact that the ECB still has room to manoeuvre, has once again acted as a cushion. Yields on sovereign debt have fallen considerably in the last few months, in many cases now at an all-time low. By way of example, the yield on German 10-year bonds stood at 0.9%, 103 BPS below the yield demanded at the end of 2013. Bonds from Spain, Ireland and Italy also saw significant reductions.

Progress is being made towards banking union and is on schedule. Q4 of this year will be important due to the publication of the stress tests carried out on Europe's main banks. The start, in November, of the ECB's role as the sole supervisor for a large part of the financial system will also mark a new phase for European banking and should help to reduce financial fragmentation. In fact, the latest data on corporate financing costs show some reduction in Europe's periphery countries, such as Spain and Italy. In addition to this normalisation in the banking sector, the ECB's liquidity measures, conditioned on banks granting loans to SMEs, should substantially support the sector's recovery.