Global Insight Perspective

Significance

The slowdown in Eurozone GDP growth in the third quarter was clearly at least partly a correction following the particularly robust expansion in the first half of the year. Latest indicators and survey evidence remain largely healthy.

Implications

Eurozone growth clearly peaked in the second quarter, but is still relatively strong. Consequently, the European Central Bank still seems certain to lift interest rates by a further 25 basis points in December.

Outlook

We expect Eurozone economic activity to gradually lose momentum over the coming months, causing GDP growth to moderate from 2.5% in 2006 to 1.9% in 2007.

Eurozone GDP growth slowed to 0.5% quarter-on-quarter (q/q) in the third quarter of 2006, according to a "flash" estimate from Eurostat. This moderation in growth was clearly substantially a correction from the particularly robust expansion seen in the first half of the year. Specifically, the Eurozone economy expanded by 0.9% q/q in the second quarter of 2006 (the best performance since the second quarter of 2000) and 0.8% q/q in the first quarter. Meanwhile, the annual rate of Eurozone growth edged back to 2.6% in the third quarter, having climbed to 2.7% in the second quarter from 2.2% in the first quarter and 1.8% in the last quarter of 2005.

French Stagnation Drags Down Eurozone Growth

Overall Eurozone growth in the third quarter was dragged down by the French economy unexpectedly stagnating following sharp expansion of 1.2% q/q in the second quarter. In addition, Italian growth halved to 0.3% q/q in the third quarter from 0.6% q/q in the second, although the annual rate of expansion remained at 1.7%. Elsewhere, growth generally held up well across the Eurozone in the third quarter. The German economy expanded by 0.6% q/q and 2.8% year-on-year (y/y), following very healthy growth of 1.1% q/q in the second quarter (boosted by the country's staging of the football World Cup) and 0.8% q/q in the first. Dutch growth similarly moderated to 0.6% q/q in the third quarter, having surged to 1.3% q/q in the second quarter.

The Spanish economy expanded by a robust 0.9% q/q in the third quarter, thereby matching the second-quarter performance and lifting annual growth to a five-year high of 3.8%. The Austrian economy also expanded by 0.9% q/q in the third quarter, resulting in annual growth of 3.3%. Meanwhile, Belgian growth was a healthy 0.6% q/q and 3.1% y/y.

Growth Appears to Have Been Broadly Based in Q3

Eurostat is yet to release a breakdown of the third-quarter Eurozone GDP components. The limited data that is available so far from the individual countries indicates that growth was largely broadly based across the region, with consumer spending, investment and exports all contributing. For example, the German Federal Statistical Office indicated that growth was supported by a renewed pick-up in exports after they had lost some momentum in the second quarter, and also reported that higher consumer spending and investment contributed to growth. Meanwhile, French GDP in the third quarter is likely to have been dragged down by a sharp reduction in stocks and negative net trade.

Eurozone domestic demand had been vibrant in the second quarter of 2006, led by buoyant gross fixed capital formation, which extended the robust performance seen in the first quarter. Investment is clearly benefiting from the marked improvement in Eurozone business confidence seen since mid-2005 and recently higher orders and production. However, consumer spending growth moderated fairly markedly across the Eurozone in the second quarter after healthy growth in the first. This highlighted the fact that consumer spending is still relatively fragile, and it is apparent that consumers continue to be relatively cautious in a number of countries about substantially stepping up their expenditure on a sustained basis.

Meanwhile, net trade lifted overall Eurozone GDP growth by 0.1 percentage point in the second quarter of 2006, following a positive contribution of 0.4 percentage point in the first quarter. Eurozone export growth slowed in the second quarter from the heady levels seen in the first quarter, but was still relatively strong.

The latest data and survey evidence generally indicates that the Eurozone economy is currently still in good shape. For example, the purchasing managers' surveys for both the manufacturing and services sectors were largely healthy in October, although they have both eased back from their June peaks. So far, foreign orders appear to be holding up despite the euro's modestly firmer overall tone in recent months and a modest slowing in global growth (the euro climbed to a one-year high of just under US$1.30 in June, and has since largely fluctuated around US$1.27).

Furthermore, overall economic sentiment in the Eurozone climbed to a five-and-a-half-year high in October, having faltered modestly in August. Business confidence is largely buoyant across the region, while consumer confidence was stable in October at its highest level since June 2002. However, consumer spending remains somewhat erratic across the Eurozone. Indeed, the latest data shows that retail sales volumes fell 0.6% month-on-month (m/m) across the Eurozone in September, although this followed reasonable gains in both August and July, and volumes were still up 0.6% q/q in the third quarter.

Outlook and Implications

We suspect that Eurozone growth will be healthy in the final quarter of 2006, but will gradually lose momentum during 2007. As a result, we forecast Eurozone GDP growth to rise from 1.5% in 2005 to 2.5% in 2006, but then to ease back to 1.9% in 2007.

We expect the euro to trend higher against the U.S. dollar over the coming months, which would obviously be detrimental to Eurozone competitiveness and growth prospects. Specifically, we forecast the euro to rise to US$1.30 by the end of 2006 and then to climb to US$1.40 by the end of 2007 as the dollar is pressurised by less favourable interest-rate developments in addition to the large U.S. current-account deficit.

Furthermore, relatively elevated oil prices are likely to remain a threat to growth, given the very tight global supply-demand situation for oil. Although oil prices have fallen back markedly from their early-August nominal record highs (Brent has consistently traded below US$60/barrel since late September compared to its early-August record high of US$78.8/barrel), we suspect that they will remain prone to upward spikes and generally strong for some time to come. Specifically, we forecast Brent oil to average US$64.8/barrel in 2006 and US$62.4/barrel in 2007.

In addition, any slowdown in global growth is also a significant threat to Eurozone growth prospects, given that robust exports and healthy foreign orders for Eurozone products have been key factors in supporting the marked overall improvement in both growth and business confidence across the region since mid-2005. There are currently growing signs that the global economy is losing some momentum—the U.S. economy slowed markedly in the third quarter—and Global Insight forecasts global growth to soften from 3.9% in 2006 to 3.3% in 2007.

Meanwhile, Eurozone interest rates have risen significantly, and are likely to increase further still. The European Central Bank (ECB) has raised interest rates by a cumulative 125 basis points between December 2005 and October, taking it up from 2.00% to the current level of 3.25%. The ECB has clearly indicated that it will lift its key interest rate by a further 25 basis points to 3.50% at its December policy meeting, and we now expect interest rates to reach 3.75% in the first quarter of 2007 and then stay at that level throughout the rest of the year. Meanwhile, Eurozone long-term interest rates have risen modestly overall from the very low levels seen earlier in 2006.

Not only does the Eurozone seem set to see a further tightening of monetary policy over the coming months, but pressure remains on many Eurozone governments to tighten fiscal policy to improve weakened public finances. Indeed, fiscal policy will be restrictive overall in the Eurozone in 2006 and 2007. Significantly, the German coalition government has prioritised reducing the country's budget deficit, while the new centre-left Italian government is also taking action to reduce its excessive budget deficit (although it has diluted its original plans). Given that the German government has announced that sales tax will rise by three percentage points in January 2007, however, some consumer spending could be brought forward to the final months of 2006 from 2007.

Contact: Raul Dary

24 Hartwell Ave.
Lexington, MA 02421, USA
Tel: 781.301.9314
Cel: 857.222.0556
Fax: 781.301.9416
raul.dary@globalinsight.com

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