Europe emerges from hibernation braced for near-term economic pain

European governments are beginning to ease lockdown restrictions which will support the re-normalisation of economies during the second half of Q2. However, none of this changes the fact that the current quarter will still be the worst quarter for the eurozone by a country mile, according to Jessica Hinds, an economics analyst at Capital Economics. “A renewed rise in the infection rate could prompt the re-imposition of lockdowns. But it provides a glimmer of hope that our forecast of a 20% q/q slump in GDP in Q2 will prove too pessimistic.”

Overall, the economic outlook will remain intrinsically linked to the development, scaled production and world distribution of a safe and effective vaccine for Covid-19. Beyond which, there are wide variations in the predicted future performance of economies. At the macro level, the important questions are around when the recovery begins and the strength of post-pandemic economic activity. The answer will vary widely between nations and will be a function of the interrelated scale of the public health crisis Covid-19 caused, the severity and duration of the societal lockdown, and the pace re-opening. Those nations which suffered the greatest health crisis will also endure a more severe economic contraction. The key data to focus on is growth and earnings from Q4 onwards. At the global level, the IMF said the world will need $20 trillion in public investment on health care infrastructure and green energy. Since its mid-April forecast which projected a 3% contraction in 2020, the global economic outlook has continued to worsen, the IMF said in mid-May. Until the health crisis is solved, the economic consequences will remain.  

Lockdown severity and GDP trend correlation

In Europe, the lifting of lockdown and the unburdening of debt have morphed into the same issue, according to Nicolas Forest, global head of fixed income at Candriam, the global multi-specialist asset manager. Eurozone governments have experienced significant take-up across national wage subsidy schemes, designed to suppress rising unemployment and support economic recovery. Capital Economics estimates around 25% of the eurozone’s pre-pandemic workforce is now on one of these schemes. In Germany, for example, an estimated 10m workers are covered by wage subsidy schemes compared to just 1.5m in early 2009, according to Germany’s Federal Employment Agency. These are incredibly expensive schemes, which provide between 60% and 80% of wages with voluntary top-ups by employers, but they have slowed the unemployment rate to 7.5%, compared to 14.7% in the US. 

Hard hit Continental nations – Italy, France, and Spain – instigated the strictest lockdown policies, while Germany and the Nordic nations have been relatively less affected and appear better positioned for a rebound. In the first quarter, the European Union’s GDP slipped by 3.5%, according to a preliminary flash released by Eurostat, while the 19-state eurozone economy shrank by 3.8%, compared to the last three months of 2019, in its fastest rate on record. However, this masks significant North-South variation. Germany’s economy contracted by 2.2% in its biggest quarterly decline since Q1 2009 and the second-largest since German unification. In the Netherlands, GDP slipped 1.7%, while in the Nordics, Sweden slid 0.3%, Denmark and Norway both fell 1.9%, while Finland grew by 0.1%. All project deeper contractions in Q2. By contrast, France, Spain and Italy – the three largest European economies after Germany – all recorded worst quarterly falls on records plunging 5.8%, 5.2% and 4.7%, respectively. France and Italy are now in recession, with Spain certain to join. The correlation between the severity of lockdown and economic contractions in Q1 are unmistakable. Moreover, the impact of the recessions and the costs of government schemes to support industries and households will push up borrowing costs among the nations whose debt to GDP is already at, or near, historic highs following the global financial crisis. 

“Looking ahead, we think that there will be very big differences in GDP growth in Q2 and beyond across the eurozone,” says Jack Allen-Reynolds, senior Europe economist at Capital Economics. “Among the largest economies, activity in Italy and Spain is likely to fall furthest in the second quarter, followed by France, with Germany experiencing the smallest decline. Generally speaking, countries with stricter and more prolonged lockdowns, and that are more dependent on tourism, will fare the worst. That group of countries includes Italy, Spain and Greece.”

But a co-ordinated European fiscal response has been slow to arrive. “Question remains what does the future hold for European budgetary and monetary policy? How can there still exist a united monetary zone when Italy’s debt is twice that of Germany’s? Should we go back to the ‘before’ model? Relaunch mass tourism, extreme globalization, uncontrolled production, and investment in oil?” asks Forest. Over the next two years, debt spreads between eurozone countries will widen – spreads of up to 100% are considered possible. 

Coronabonds won’t go away

The most workable solution in Europe may well be the return of the notion of joint issued European debt in the form coronabonds. This financing instrument long debated within Europe before the virus and emblematic of the deep inequalities within Europe that have been stoked further by this crisis. Unfortunately, there has been as much, if not more, evidence of political division than unity within Europe, such as in the protracted legal dispute between Germany’s supreme court and the European Central Bank. Germany’s constitutional court ruled that the ECB’s Asset Purchase Program (APP) partly contravenes German law because neither the German government nor its parliament signed off on the spending. The ruling calls into question the ECB’s supposed independence on monetary stimulus policy. There are obvious legal contagion risks here: if this is true for Germany, is it not equally true for other European nations? Some have speculated this may even threaten the future of the euro. It is an issue that has been slowly simmering for years brought to a boil by the health and economic emergency which coronavirus has triggered, undermining European solidarity and the ECB’s “whatever it takes” message during its most severe economic challenge in history. 

In the context of which, ECB president, Christine Lagarde, is still expected to push on undeterred. Lagarde said last Friday that additional debt issues by governments within the EU will be in the range of €1 trillion to €1.5 trillion in 2020 alone. Without the ECB as a backstop to buy up this expected massive sovereign debt issuance, borrowing costs will spike which will hurt the recovery of economies struggling the most which risk greater economic divergence and future inequality. This would create a perfect storm for a populism revival. 

Europe’s North-South divide: between and within nations

The eurozone economy is experiencing the fastest and deepest economic contraction since the Second World War. The differences between, and within nations, is stark. The recovery is expected to be slow and shallow in Italy, France and Spain, compared to Germany, the Netherlands, the Nordics, and Austria, for example. 

But the recovery within Italy, France and Spain with be even more sluggish and muted in the tourism-dependent southern provinces of Italy, France and Spain, compared to those nations’ wealthier, urban northern capitals and surrounding provinces. Greece and Portugal can similarly be added to the list of Southern European nations expected to languish post-pandemic, in yet another cruel example of how the pandemic has exacerbated long-established regional inequalities. And again, the perfect storm for populism’s revival could see extra impetus within these Southern regions. 

Governments are spending unprecedented amounts of money supporting economies and households through the coronavirus pandemic. It is vital attention turns to social inequalities which fall on the most vulnerable are prioritised as the pandemic aftermath unfolds. 

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