European Economics: stronger cyclical headwind and higher political pressure

Part of a report of Morgan Stanley – Spring European Economics Outlook

Cutting European GDP growth forecasts 
In light of tighter financial conditions, weaker global growth and rising political risks, we are cutting our full-year real GDP forecast from 1.8%Y to 1.5%Y. Hence, investors will have to wait until 2H16 before growth moves towards a 2%Y pace. Euro area GDP growth continues to be supported by expansionary fiscal policy, low oil prices and loose monetary policy. While consumer spending is likely to stay resilient, also thanks to rising wage income growth, we are getting concerned about investment spending going forward.

Inflation pulled below zero, but not for long 
A renewed fall in oil prices has pulled headline inflation lower again. The recent rebound in oil prices suggests that this one-off effect on headline inflation will likely be limited. Still, we are revising down our full-year estimate for 2016 from 1.3%Y to 0.2%Y. Our 2017 forecast stays broadly unchanged and comes down only marginally to 1.7%Y. But it should take until late 2017 for inflation to return to the ECB’s price stability objective. We therefore expect the ECB to cut the deposit rate to -50bp in 3Q and place a near even chance on the ECB upping and extending its purchases to other assets.

Politics dominating the debate in Europe 
With the election cycle in the periphery completed, albeit with inconclusive outcomes, focus is moving towards Europe more broadly, notably a potential exit of the UK from the EU and a possible permanent suspension of Schengen in reaction to an unmitigated influx of migrants. ‘Brexit’ would likely have a material impact not just on the UK and a suspension of Schengen would mark an unprecedented reversal of European integration. Both undermine the functioning of the Single Market, the EU’s major achievement.

Source: Morgan Stanley Research Europe