Weekly Analysis
Typography

Monthly survey data show that economic activity growth remains robust at the beginning of 2018.....

The reading helps create a favourable underlying context, which offsets the populist drift which is emerging from the election campaign. In 2018 as well, growth will stay above 1%, aiding an initial reduction of the debt/GDP ratio.

The agreement reached in Germany for the formation of a government coalition creates the conditions for a dialogue on reforming the Eurozone. The completion of the banking union and the creation of a basic level of shared fiscal capacity may become a little more plausible as a result. However, the reduction or risk remains an essential precondition for any agreement.

In the United Kingdom as well, a change in pace in monetary policy is on the cards. The Bank of England sees risks to the achievement of the inflation target, and therefore warns that rate hikes could come sooner and be swifter than envisaged in November. However, the scenario remains hard to manage due to the negotiations on exiting the EU.

Italian industrial output data reaccelerated clearly in December 2017, after two slow months, with the quarterly change rising to 0.8% q/q based on seasonally adjusted data. This marks a slowdown compared to 3Q 2017 (1.5%), but also strengthens expectations for a positive start to 2018, thanks to the resulting pull effect. Forecasts for a growth rate above one per cent this year as well remain solid for now, and there could be some upside risk to our estimate of 1.3%. Therefore, the run-up to the vote on 4 march is taking place in a context of strong GDP growth compared to the average of the past 20 years, with unemployment on the decline and a recovery in the disposable income of households after the blow incurred with the deep recessions of 2008-09 and 2011-12. Growth should also make it easier to achieve a reduction of the debt/GDP ratio, constantly pushed back over recent years. Other developments are helping improve the country’s reputation abroad in the present phase: strengthening capital ratios and the improvement in asset quality in the banking system, the swift reduction of net foreign financial liabilities, the trade surplus, low investor exposure to the Italian market. The structure of the economic and financial system seems far more resilient today than it was eight years ago, and this helps shield investors from the potentially negative effects of an election campaign that has not only sidelined the reduction of public debt, but also turned into a competition in making electoral promises that are as generous as they are unrealisable.

The agreement for the formation of a coalition government in Germany was achieved thanks to major concessions made to the Social Democrats, which will also control the Finance Ministry. This government’s approach to European policies promises to be much more open than would have been the case with an alliance with the Liberals. Therefore, dialogue with France on changing European governance could make progress. Italy is unlikely to play a significant role, however, given the impending elections and the absence of a shared vision among political forces on which reforms should be pursued. Furthermore, expectations should not be too high neither in terms of the scope of the reforms (there is no political will to transfer fiscal sovereignty from member states to the EU), nor on the possibility of carrying them through without first taking on the issue of risk reduction.

This latter aspect has remained prominent in all the documents on the future of the monetary union, in various forms. One concerns the quality of bank assets, a front on which swift progress is being made. Another concerns the link between the sovereign issuer and banks, which prompted the ESRB’s work on safe bonds, recently published. In this front as well, the diversification of the government bond portfolios held by Italian banks has increased.

Then there is the issue of the sustainability of debt, considered to be still at high risk by the European Commission in its January report for Italy, Belgium, Portugal, Spain, and France. As a corollary to doubts on sustainability, in addition to design more effective mechanisms to force fiscal restraint on reluctant Member States, pressure is also being exerted towards the introduction of dangerous debt restructuring automatisms in the event of a country experiencing refinancing difficulties. Consensus for solidaristic mechanisms is unlikely to gel unless Italy sets out convincingly along the debt reduction path.

The monetary policy reversal could change pace even in the United Kingdom, after the US. The Bank of England signalled on Thursday that the rate hike could take place sooner and at a stronger pace than initially envisaged in November. According to the latest staff forecasts, excess demand could start to be an issue in the country in a matter of two years, which could place at risk the return of inflation to the 2% target rate.

The BoE forecasts full re-absorption of unutilised resources, slower production capacity growth than output growth, and upward pressures on wages. However, the Bank of England is faced with a specific problem, which is the United Kingdom’s exit from the European Union. If a long transition period is agreed on beyond March 2019, as still seems likely, a change in pace of monetary policy tightening will become inevitable.

However, a retracement could still be on the cards in the event, possible albeit not likely, of negotiations falling through, resulting in a disorderly Brexit in 2019. For the time being, the BoE is behind the curve, merely adjusting its guidance towards what markets already price in – i.e., a new rate hike possibly as early as May 2018.

The week’s market movers

In the Eurozone, 4Q GDP growth estimates should point to slowdown in Germany, to 0.6% q/q from 0.8% q/q, and in Italy to 0.2% q/q from 0.4% q/q. In the Netherlands, on the other hand, GDP should be up by 0.6% q/q from 0.4% q/q the previous quarter. The second estimate for Eurozone should confirm GDP growth at 0.6% q/q in 4Q 2017, from a previous 0.7% q/q. Recent data suggest that the recent expansion phase is continuing at a solid pace also in early 2018 in most euro area countries.

This week, a host of important data will be released in the United States. The initial set of manufacturing sector surveys for February should improve, after correcting moderately in January, due largely to weather conditions. January price indices (CPI, PPI, import prices) should confirm the moderate trend, with the core CPI on the rise by 0.2% m/m. Industrial production, retail sales, and housing starts, should all mark moderate monthly increases in January, compatible with a positive trend, but not as brilliant the one seen in 4Q 2018.


Appendix
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