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Euro zone economy: Brighter, but challenges remain

27 April 2018 | Markets and Economy

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Commentary by Alexis Gray, Vanguard senior economist.

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There have been plenty of economic and political surprises over recent years and, for me, one of the most encouraging has been the turnaround in the euro area.

Several years ago the euro area was in the doldrums with high unemployment, low growth and many angry and unhappy citizens. This led to concerns that one or more countries may choose to leave the euro, potentially triggering a financial market panic.

Fast forward several years and the euro area is making great strides. Across the region, unemployment is falling and, in some cases, is close to pre-crisis levels. Business and consumer confidence have also risen dramatically.

Why has the euro area turned around?

Several factors have driven the improvement in the euro area: the end of austerity; an improving global economy; and vast amounts of stimulus provided by the European Central Bank, which eased financial panic.

The austerity adopted by governments after the financial crisis was well-intended. It involved efforts by government to constrain debt by increasing taxes and spending less. This was designed to raise the financial markets' confidence that governments were solvent and all debts would be repaid.

The trouble with the austerity programme was that it was ill-timed. The economy was in recession when austerity was introduced. So when governments across the euro area, and particularly in the periphery, made cuts to basic government services, pensions and infrastructure, those cuts exacerbated and prolonged the downturn. This led to higher unemployment and homelessness and drove many young people in struggling countries to move abroad in search of work.

Governments eventually started to spend again as the recovery emerged and tax revenues increased. By that stage, however, the economic recovery was several years behind that of the United States and the United Kingdom, who had not pursued such aggressive austerity measures.

Significant challenges remain

The euro is now on a firmer footing, and the short-term risk of an economic or financial crisis has diminished. The region nonetheless faces many challenges. The two major economic challenges are an ageing population and poor productivity growth – both of which imply that the current high rate of economic growth can be sustained for one or two years, but is unlikely to persist over the long term.

The key political challenge for the euro area is to address frustrations among the general public, which may lead to the election of populist political parties or, at an extreme, lead a country to opt out of the euro area or the European Union.

In recent years, attitudes towards both the euro and the European Union have improved as the economy has recovered (see chart below). Nonetheless, plenty of Europeans remain unhappy. According to a recent study by the European Parliament, the top concerns listed by citizens of the EU are terrorism, unemployment, tax fraud, migration and the protection of external borders.1

Attitudes towards the euro and the European Union have improved

Percentage of Europeans who think membership in the EU or the euro area is a good thing:

approval chart

Source: Eurobarometer and the European Parliament.

These frustrations were evident in the 2017 and 2018 national elections across France, Germany, Italy, Austria and the Netherlands, where populist parties received a larger share of votes than in the past. Similar concerns were also expressed in the UK's 2016 decision to leave the European Union.

For now, the risk of a break-up of the euro currency union, or the larger economic union, remains low. The economic recovery has gained momentum, which has reduced stress on the region, and support for the euro is at an all-time high. And with the euro area entering the second honeymoon period since its inception in 1999, European policymakers are taking the opportunity to debate new reforms which will shape the future of the euro. Given the amount of disagreement between member states, it remains to be seen whether these debates will lead to swift changes.

What does this mean for investors?

  1. Increased European political risk may lead to occasional bouts of global market volatility. For this reason, it is always wise to hold some of your portfolio outside of Europe, as global diversification can be a great way of reducing risk and providing additional sources of return over the long term.
  2. Interest rates are unlikely to rise in the euro zone before mid-2019. However, if the economy continues to outpace expectations, we may see the market start to price in earlier increases. The impact of rate hikes on financial markets is not always straightforward, but diversifying between equities and bonds should help to reduce the effect of weakness in one or other asset class.

Alexis GrayAlexis Gray
Vanguard senior economist

1 Source: Eurobarometer survey of 27,901 EU citizens conducted on behalf of the European Parliament in March 2017 by Kantar Public.

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The opinions expressed in this article are those of individual authors and may not be representative of Vanguard Asset Management, Limited.

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