Eurozone: Second leg of the recession coming up

With the seemingly unstoppable increase in Covid-19 infections and the consequential pressure on health systems, most eurozone countries have been forced to put in place more stringent confinement measures again. While schools and companies remain mostly open, at least for the time being, bars and restaurants and non-essential stores have been closed in several of the bigger member states. Add to that a higher level of sickness-induced absenteeism and the negative impact on confidence, and negative growth in the fourth quarter seems hard to avoid.

The spectacular 12.7% non-annualised GDP growth in the third quarter was no more than a mirage, cause by the reopening of the economy after the lockdown constrained second quarter growth. Interestingly, amongst the bigger countries, the snap back has been proportional to the GDP contraction in the second quarter, meaning that most are now close to each other in terms of year-on-year contraction. Spain remains the odd one out, with a much deeper recession.

Manufacturing started the fourth quarter on a strong footing, with PMI figures for October pointing to solid growth. However, the retail sector and services are going to be hurt again by the confinement measures, not to mention the negative effects on confidence. The fall in consumer confidence in October doesn’t bode well in that regard. We now expect a 2% GDP contraction in 4Q with risks skewed to the downside. Because of the very strong 3Q growth, we had to revise our 2020 GDP growth estimate upwards to -7.1%, but at the same time we lowered our 2021 forecast to +3.5%. Indeed, this time, authorities will probably be more prudent in the loosening of confinement measures, signalling a rather weak start to the year as a result. Only from the second quarter onwards should things speed up, as this is when a vaccine will probably start to be rolled out. Meanwhile, inflation remains uncomfortably low, with core inflation still at a mere 0.2%. With German elections in 2021 and taking into account the fall back into recession, we think the German government might refrain from hiking VAT rates in January, which will probably keep average eurozone inflation below 1% next year.

While the ECB held policy steady at its October meeting, there was a clear signal from President Christine Lagarde that fireworks are in the offing at the December meeting, with a “recalibration of its instruments”. We expect an additional €500 billion in quantitative easing, possibly announced as a monthly instalment and continuing as long as needed. To keep financing costs low, the preferential Targeted Longer-Term Refinancing Operations (TLTRO) rates (allowing the banks to fund themselves cheaply if they don’t shrink their credit portfolio) are probably going to be lengthened until the summer of 2022. An increase in the tiering for excess liquidity, exempting a bigger chunk of bank liquidity from the negative deposit rate, is also likely. Just like the Federal Reserve, the ECB might also decide to incorporate bonds of “fallen angels” (companies that lost their investment grade rating this year) into its corporate bond purchase programme. While a deposit rate cut cannot be excluded, it is probably not the most preferred policy measure at the current juncture.