Eurozone: Second wave balancing act

The dreaded second Covid-19 wave seems to be materialising in Europe, though a repeat of the scenes of overcrowded hospitals, like we saw in March/April, can probably still be avoided. That is basically the reason why several European governments (Spain, France, the Netherlands, Belgium,…) have announced a tightening of Covid-19 measures as well as return to targeted lockdowns.

This might raise the spectre of a double-dip recession. The PMI indicator already fell in September on the back of a weakening services sector. While the European Commission’s economic sentiment indicator still saw progress in the services sector last month, expectations deteriorated.

To be sure, the third quarter will likely show stellar growth: we pencil in a 9% non-annualised quarter-on-quarter GDP growth rate. Very strong retail sales in August seem to confirm that the opening of the economy boosted consumption over the summer months. But a number of factors are likely to lead to much weaker growth over the next two quarters. Apart from the tightening of Covid-19 measures, there is the risk that second-round effects will manifest themselves in a more pronounced way: companies that refrained from lay offs until now, might be forced to reduce manpower in the wake of renewed confinement measures, especially as temporary unemployment schemes will gradually peter out in most countries.

On top of that, we mustn’t forget that the crisis seems to have accelerated a number of structural trends (like digitisation) that might have a disruptive effect on the European economy. For example, the shift to home working and electric cars is leading to an important restructuring in the German car industry (even though Germany is coping better than most other countries on the back of massive fiscal stimulus). Finally, the European recovery fund seems to be in for some delay, while the Brexit negotiations will, at best, deliver a limited trade agreement, which both blur the outlook for 1Q growth. While we maintain our -8% forecast for 2020, we have reduced our 2021 forecast to +4%, with the risks still skewed to the downside.

HICP inflation surprised to the downside again, with headline falling to -0.3% and core inflation printing a mere 0.2% in September, the lowest level since the start of the monetary union. While changes in the sales period over the summer months have distorted inflation figures, the unrelated fall of services inflation to 0.5% clearly demonstrates the deflationary impact of the Covid-19 crisis. Hence, we have revised our inflation forecast down to 0.3% for this year and 1.1% for 2021.

With the ECB in the midst of its strategy review, it is not yet clear how the bank will redefine its inflation target. In some preliminary considerations, ECB President Christine Lagarde opened the door to a more symmetric inflation target, not discarding the possibility of a Fed-like average inflation aim. In any case, the Governing Council cannot ignore the current trends and will have to add stimulus. We still consider a rate cut as a low probability outcome (though not impossible), but stick to our forecast of an additional €400 billion in asset purchases to be announced before the end of the year. It is likely that these purchases would be made under the Public Sector Purchase Programme to give the impression of more permanency, as the Pandemic Emergency Purchase Programme was set up as a temporary tool to fight the crisis.