Is Europe’s recovery canceled?

Recent political developments have taken center stage in Europe, with the right-wing National Rally securing first place with a third of the vote in Sunday’s first round of France’s legislative election. Because of this, less attention has been given to the continent’s incoming fundamental data.

After a series of positive surprises, eurozone economic releases have disappointed in the last two weeks of June. As a result, the bloc’s Citi economic surprise index has turned negative for the first time since late January, raising the question: has Europe’s recovery been canceled?

According to Gavekal Research, the answer is “most likely not,” though it does indicate that despite recent stabilization, demand remains subdued.

European Commission surveys show that the share of eurozone businesses citing demand as a constraint on activity rose to 34.2% in the second quarter of 2024, up from 33% in the fourth quarter of 2023, and above the long-term median of 31.7%.

“If this proportion does not fall, the recovery will struggle to gather strength,” analysts at Gavekal Research said.

Analysts note that there are positive signs for domestic demand to strengthen in the second half of the year and beyond. In the first quarter of 2024, nominal wages rose by 4.8% year-on-year.

With HICP inflation at 2.4%, this resulted in a significant 2.4 percentage point increase in real wages. After three consecutive quarters of rising real wages, eurozone consumers have now regained half of the real income losses they experienced during the inflationary surge of 2022-2023.

“A tight labor market means the pass-through of past inflation to wage demands should keep nominal wage gains well above inflation’s range of 2% to 3%, even if wage rises now moderate,” the analysts wrote. “This dynamic should help boost consumer spending.”

The report also points out that the missing piece of the recovery puzzle is a convincing upturn in the bank lending cycle. Monetary data released on June 27 indicated an upward trend in bank lending.

As of May, the six-month moving average of new bank lending to households was €2.5 billion, while lending to non-financial corporations was €2.2 billion. The European Central Bank’s rate-cutting cycle could further boost this emerging upturn by making bank credit more affordable.

While the ECB is likely to be cautious about easing, any upturn in bank lending will be gradual, the analysts stressed. Although the trend appears positive, bank lending volumes are unlikely to return to the levels seen in 2021-22 soon. Given the eurozone’s reliance on bank lending over capital markets, the willingness of banks to lend will significantly influence domestic demand.

Despite the lack of a forthcoming credit boom, lower interest rates should boost domestic demand through two channels.

First, by reducing the private sector’s debt-service burden, particularly in Southern Europe, where borrowers are more sensitive to rate changes due to their exposure to variable-rate loans. Second, lower interest rates reduce the return on savings accounts, decreasing the opportunity cost of consumption and helping to lower the household savings rate.

Looking ahead, a potential concern is fiscal policy, Gavekal’s report says.

The EU, having suspended its fiscal framework from 2020 to 2023, is reintroducing fiscal rules this year. On June 19, the European Commission threatened to initiate “excessive deficit procedures” against France, Italy, Belgium, Malta, and Slovakia, which together account for 39% of eurozone GDP.

Though these countries may need to consolidate their public finances, the new fiscal framework is less stringent than before and remains untested in its milder form. Implementation will depend on the new European Commission, which will take office in November.

“In short, eurozone domestic demand is not about to come roaring back. But the conditions are in place for a solid improvement by the end of this year,” the analysts concluded.