KfW Business Cycle Compass Euro Area: Investment shows signs of life

• Forecast confirmed: 1.6% in 2016, 1.8% in 2017
• Consumption and investment drive growth
• Brexit is main risk to the economy in the short term

The euro area came out of the starting blocks well in 2016 and surprised with strong 0.6% first-quarter growth sustained by domestic demand. Along with consumption expenditure, investments are also making a decent contribution to growth. Concern over the performance of the emerging market economies and some European banks does not appear to have impressed consumers nor investors in any significant way, unlike the financial markets. But there is no cause for euphoria, and the fundamental growth momentum is probably weaker than what was signalled by the good start to the year. KfW Research therefore confirms its previous growth forecasts for the euro area and expects growth of 1.6% for 2016 and 1.8% for 2017.

A slowdown in the pace of growth is likely, especially in the second quarter of 2016, before it accelerates again in the second half of the year. For one thing, the mild weather conditions of the past winter led to higher than normal economic activity, especially in the construction industry. For another, after a strong January, industrial output in the euro area was down significantly over two consecutive months – a liability for the start to the new quarter. The UK referendum on the Brexit and the June elections in Spain are once again causing major political uncertainty.

“In order to place the euro area recovery on a stable foundation, the investment restraint that has persisted since the financial market crisis must come to an end. So it is all the more important that somewhat stronger investment growth of +0.8% is now discernible in the second consecutive quarter”, said Dr Jörg Zeuner, Chief Economist of KfW Group. “Gross fixed capital formation has still not managed to climb above the level of late 2010, but the chances for businesses to continue their urgent expansion and renewal of capital stock are fundamentally good thanks to the favourable financing environment and brighter economic outlook.”

Convergence among the member states of the euro area has recently evolved further, which is of crucial importance for the medium-term stability of the single currency area. The four major euro countries Germany (+0.7%), France (+0.6%), Spain (+0.8%) and Italy (+0.3%) all maintained or accelerated their pace of growth. Investment activity also increased in all four countries. However, there are warning signs that their economic development may drift apart once again. A glance at the most recent ECB data on the development of loans to non-financial corporations shows this. While credit exposures to large enterprises are growing in France (+4.5% on the previous year) and Germany (+3.5%), the recovery on the credit markets in Spain (-1.5%) and Italy (-1.9%) is stagnating. If these trends solidify, the challenges for the single monetary policy will grow further.

“In the short term, a Brexit is the main risk to the economy. Should Britain vote to leave the European Union, that would put a significant strain on the recovery in the euro area”, said Zeuner. The handling of economic and political crises also remains a downward risk for the euro area. While crises are being successfully contained, they are usually not fundamentally overcome, he added. “One commonality of such diverse matters as the Greek debt crisis, refugee migration and the high volume of non-performing loans in parts of the European banking system is that none of these problems has been conclusively resolved. However, that turns them into latent risks that hamper economic activity through uncertainty and can significantly compromise the economic recovery if they become acute.”

The current KfW Business Cycle Compass Euro Area is available for download at: www.kfw.de/KfW-Business-Cycle-Compass-Eurozone