The EU-Commission’s Economic Sentiment Indicator (ESI) showed another increase in October from 113.2 to 114. This is the highest level since 2000, surpassing the optimism in the years prior to the financial crisis. For the euro area as a whole, there were increases in all subcomponents with construction increasing the most during the last year. The construction index is now at the highest level since 2005.
The ESI-index is strongly correlated with GDP growth on both the euro area level and country level, although a specific level of optimism corresponds to different levels of GDP-growth in the various countries.
Among the four biggest countries, Germany saw the largest increase of 2.1 points to 114.5. This is the highest level since 2011, when the German economy grew by more than 5%. Particularly manufacturing and construction have risen sharply over the past year with construction at the highest level measured. This corresponds well to a strong global investment cycle and the massive need for housing construction to accommodate migrant workers and refugees that have boosted the German working-age population. German employment has increased by 3.6 million since the beginning of 2010 and by 400,000 so far this year.
Both consumer and service optimism have gained, but far less than the production sectors – and are far from previous peaks. Private consumption grew 2% y/y in Q2 and I expect it to stay around this level in the coming quarters. With construction and business investments picking up speed – and a positive contribution from net exports – GDP-growth should head north of 2% in 2018.
A small French setback after strong gains
France was the only larger euro-area country to experience a decline in the ESI index in October, but this comes after a period of strong increases. France has made the largest gain during the last year of the biggest countries. The current level of 110 indicates GDP-growth of 3.5% annually – far above the current GDP growth rate of 1.8%.
France is affected by strong cyclical winds as labor market reforms and corporate tax cuts should support business investments, along with a stronger global business cycle. President Macron’s attempts to finally deal with France’s chronic budget problem add headwinds. The retail and construction sectors saw small gains in October, while manufacturing and services declined. The current level of manufacturing optimism matches the peaks in 2011 and 2007, so still very good.
Spain powers ahead
The Spanish ESI index increased marginally to 110.2 in October and thus cements the gains in previous months. The Spanish economy has been growing by more than 3% for two years now, and the ESI-index points to a continued strong performance. Exports have been an important factor in the recovery, surging by more than 50% since 2009 as labor market reforms and wage restraint have improved competitiveness. Investments in machinery and capital goods have increased 36% since 2012, almost reaching the previous peak in 2008. One of the components I find particularly interesting is construction, where optimism has recovered sharply. House prices have started increasing again and construction activity has been rising since 2014.
With increases in all subsectors except retail, there is little evidence in the EU-Commission’s survey that the political challenges in Catalonia has manifested itself in economic optimism. However, data have been collected before the unilateral declaration of independence and the triggering of article 155 of the Spanish Constitution.
Italy, the laggard
The economic sentiment improved further in Italy in October, reaching 111.9. It now matches the peak of 2006 and indicates GDP growth of 2% annually. There has been a marked improvement since June for all sectors except construction. Part of this is related to receding fears about the banking system and better domestic demand. Moreover, the labor force and the employment rate has increased substantially since Mario Monti’s labor market reforms, especially for women. Because of the growing labor force, the stubbornly high unemployment rate of 11.2% is an inferior indicator of economic performance.
The Italian economy grew 1.5% annually in Q2, and the latest increases in confidence – along with strong manufacturing orders – should allow growth to surpass the government’s 1.1% projection for 2017. However, Italy remains a laggard in implementing structural reforms and has relied heavily on ECB’s QE program to reduce interest expenditure. The budget improvement since 2012 has been due to declining interest expenditure, not an improved primary balance. Hence, QE has been a mixed blessing for Italy as lower financing cost has allowed politicians to shy away from implementing unpopular measures. With QE tapering under way and elections looming no later than May 2018, Italy could well be the biggest obstacle in the euro area.
The euro area recovery is gaining traction across countries and sectors, thus strengthening the economic foundation and increasing the ability to produce a self-sustaining growth trajectory. While electoral risk is high in Italy, territorial integrity a challenge in Spain and political inaction a risk in France, the economy seems to be improving without political interference.
There is little market-based inflation pressure in the euro area (both German and Spanish headline inflation declined more than expected in October). This is partly due to slack in the labor market, but perhaps more importantly due to the improved labor-market flexibility from structural reforms, increased global competition and the free mobility of capital. Increased competition in the retail sector is also dampening price pressures. However, core inflation does not have to tick up much from current levels, before ECB will have to answer one of the questions Draghi deflected last week: What will the ECB do, if conditions improve beyond expectations?
Today’s ESI numbers are a clear indication that risks to the euro area growth outlook are currently to the upside.