Eurozone's economy shines through in year of political strain

Frankfurt -  Even as Catalonia serves a reminder that political risks remain, the euro area’s year of living dangerously is turning out well for the economy.

On track for the strongest expansion in a decade and with consumer and business confidence at the highest since before the financial crisis, the 19-nation currency bloc is emerging as fertile ground for dealmakers, investors and executives.

“The wind is well and truly back in the sails of Europe,” said Simon Wells, chief European economist at HSBC. “The question for investors I suppose is: can this continue?”

The upbeat economic outcome for 2017 wasn’t at all certain at the start of the year, when the shockwaves from votes for Brexit and Donald Trump were prompting warnings that the euro area would be the next to witness a populist surge that could splinter the currency bloc.

Catalonia’s illegal independence referendum on Sunday, which could see separatists make a unilateral declaration as soon as this week to split the region from Spain, showed that the risks are far from over.

Yet they have abated. German Chancellor Angela Merkel has to deal with a rise in support for the far right but she’s still readying for a fourth term in power. At the same time, newly-elected French President Emmanuel Macron is pushing a reform program and fellow European Union leaders are planning deeper integration.

“The period of confusion may cause a dent in Spanish economic sentiment,” said Holger Schmieding, chief economist at Berenberg in London. “For the euro zone as a whole, the possible Catalan impact will probably be too small to make a noticeable difference.”’

The  European Central Bank forecasts an economic expansion of 2.2% this year, enough to persuade President Mario Draghi to consider slowing the institution’s extraordinary monetary stimulus. The Governing Council is slated to take that decision as soon as next month.

Euro-area unemployment data on Monday will probably show a decline to 9% in August - the lowest level since early 2009 though still more than twice as high as the UK or US.

A purchasing managers survey the same day should show manufacturing activity at the strongest in more than six years, and economic confidence is at a decade high.

Mergers & acqusitions

Investors have responded by pushing the Stoxx Europe 600 up more than 7% this year, headed for the strongest gain since 2013. European takeovers have jumped 41% to $526bn, offsetting a slowdown in US deals, according to data compiled by Bloomberg.

Consumer transactions - such as French lensmaker Essilor International SA’s purchase of Luxottica, the producer of Ray-Ban sunglasses - are leading the increase, reflecting growing optimism that job creation will boost household demand.

“Confidence is rising,” Marco Settembri, head of Nestle SA’s European business, said on Tuesday. “People are more confident to spend.”

Politics could still get in the way. Italians will vote to chose their parliament next year, with the euro-skeptic Five Star Movement set to make a strong showing. Merkel may have won the German election but her party still had its lowest share of the vote since 1949 as the far-right Alternative for Germany made gains.

That might throw a spanner in the works for Macron’s vision for overhauling the world’s largest trading bloc, where Germany’s cooperation - from setting up a common eurozone budget to potential harmonization of corporate taxes - would be essential.

Euro upside

The brighter economic outlook and political stability are also helping to push up the euro, which has risen 12% against the dollar this year and almost 6% on a trade-weighted basis. While the single currency has stabilised in recent weeks - and fell after the Catalan referendum - options show upside risk.

That’s worrying for the ECB because it depresses import prices and so curbs inflation, complicating its discussion on whether to start paring back on its asset-purchase program. It also makes exports less competitive, an issue for countries such as Italy that rely heavily on foreign sales and haven’t quite healed the wounds from the recent crisis.

HSBC estimates for every 10% jump in the trade-weighted euro, exports fall by 5%, and says net trade is going to be a drag on growth.

Bloomberg Intelligence predicts the expansion will slow slightly in the third quarter and decelerate further into the end of the year as the economy approaches its potential, according to BI economist Maxime Sbaihi. The ECB itself forecasts a slowdown to 1.8% in 2018 and 1.7% in 2019.

One warning sign? An unexpected decline in German business confidence for a second month in September. The region’s biggest economy also saw unemployment fall to a new record low last month - at 5.6% - but even it is struggling to lift wages and inflation.

“We probably are right around the peak,” said Jack Allen, an economist at Capital Economics in London. “But that’s not to say that we don’t think that things will continue to get better. Unemployment will keep on falling, gross domestic product will also keep on rising and, at least by euro-zone standards, the economy will continue to expand at a decent rate.”

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