Europe’s outlook: A fiscal fillip sustains the modest recovery – Goldman Sachs

Research Team at Goldman Sachs, notes that the Euro area’s modest recovery during 2015 and 2016 owed to support from a weaker Euro, lower oil prices and an easing in domestic financial conditions.

Key Quotes

“However, with the impulse from a depreciated currency and energy prices dissipating, and little headroom for further easing in credit conditions now that bank lending rates in the periphery have re-converged to core levels, the broad based support for Euro area growth is fading.”

“Nevertheless, we expect the Euro area to keep on growing at slightly below 1½% over the forecast horizon (more specifically at +1.4%yoy in 2017 and 2018, and at +1.5%yoy in 2019 and 2020). The reason for this resilience: easier fiscal policy will underpin the Euro area recovery.”

“Next year we expect fiscal policy to contribute 0.5pp to Euro area GDP growth. Prima facie, with headline 2017 GDP growth at +1.4%yoy, the relative contribution from fiscal easing in 2017 seems modest. However, given that potential growth is likely just below 1.0%yoy, at least in an accounting sense fiscal policy is responsible for almost all above-trend growth.”

“Fiscal policy’s increasingly important role in supporting the Euro area outlook is facilitated by ECB asset purchases and the ‘fiscal space’ they create on heavily indebted governments’ balance sheets. Looking forward, we continue to expect the need to cap peripheral yields in an environment of lacklustre nominal growth and high debt to GDP ratios so as to maintain fiscal space to lead the ECB to extend its purchase programme.”

“More specifically, we expect the ECB to announce an extension of its asset purchase programme until end-2017 at its December meeting. Should the scarcity of eligible assets in some market segments become a constraint, the existing self-imposed limits on purchases will be relaxed, with a move away from the capital key doing the heavy lifting. But the recent global fixed income sell-off has relaxed these constraints, at least temporarily, giving Mr. Draghi some respite from having to introduce such politically sensitive measures.”