Consensus growth expectations for the eurozone in 2019 hit 2% in the spring of 2018, but have since fallen to 1.3%. This figure will likely fall further as the consensus catches up with weak economic data released recently. What has happened? And is there any predictive power in these forecasts? And perhaps more importantly, what does it imply for our strategy as multi-asset investors?
Using macroeconomic models, we can forecast growth levels with a reasonable degree of accuracy if we assume that circumstances for the coming year remain unchanged. We are also able to build into our forecast the effects of policy changes like tax cuts. Even in this circumstance, the margin of error is already quite significant. The problem of forecasting growth gets a lot bigger, however, when large binary (political) events occur.
In these circumstances, we think it's much more important to consider a range of scenarios, instead of focusing on one single figure. We therefore constructed a menu of options for the eurozone. Currently, there are four events on the menu for the eurozone: new tariffs on EU exports to the US, Brexit, the US-China trade war and Italian politics.
Hors d'oeuvre: potential growth +2.0%
In an ideal world, the eurozone should be able to grow in 2019 by around 2%, which was the growth trend from 2014 to 2018. More recently, however, this figure has fallen to around 1%. However, it should be able to keep growing above trend as there is still spare capacity, a supportive fiscal stance, a strong labor market and a very supportive monetary policy.
This estimate is reached, however, before any costs are incurred for the various potential events in store for 2019.
Starter: Car tariffs -0.4%
The US commerce department has drafted a report on this issue, which, although not made public, likely states that foreign car imports represent a national security threat. President Trump has 90 days after receiving the report to decide whether to act.
There is a strong possibility that tariffs or import quotas will be imposed on eurozone car imports. Trump has said that he wouldn't impose tariffs as long as trade talks are making progress, but so far the negotiations are not running smoothly. The EU and the US differ on many points, including the US demand to include agricultural products in the talks. Politically this will be almost impossible for the EU to agree to due to public opposition to allowing imports of US food produced under more relaxed food safety rules.
A tariff of 25% on car imports, which has previously been proposed by Trump, will shave of around 0.4% of eurozone growth. The EU is likely to retaliate, leading to restrictions on US imports to the EU as well.
Main course: "No deal" Brexit -1.5%
Our baseline expectation is that in these weeks votes in the UK parliament, the end-of March Brexit deadline is extended. The majority of the UK parliament is opposed to a 'no deal' scenario, which makes an extension more likely. At the same time, the UK parliament is currently not able to agree on anything. If they do not agree on an alternative the UK will fall out of the EU on 29 March or they might fall out after the extension expires.
If a version of the current deal is approved or if the deadline is extended beyond 2019, we only expect a minimal drag on growth as the shape of EU-UK relations, under these outcomes, will not change materially in 2019.
Side dish: US-China trade -0.4%
The eurozone is a relatively open economy and a global slowdown is often quickly felt in the region. For instance, in 2017 the world economy was experiencing an upswing and net trade contributed 0.8% to eurozone GDP. In 2018 growth slowed down and the contribution shriveled to just 0.2%. This decline was largely attributable to the slowdown in China.
If the US does hike tariffs to 25% on the $200bln worth of Chinese exports, we expect a further weakening of the Chinese economy. The eurozone is caught in the crossfire and will in that case likely slow by around 0.4%, although that estimate is highly dependent on policy measures and the reaction of China.
Dessert: Italian politics -0.2% to -3%
The impact of Italy is even more of a wildcard than the other events.
Italy makes up around 15% of the eurozone economy. The key question is whether investors remain willing to finance Italy. If markets lose their confidence in Italian economics or politics, it could quickly lead to a rapid tightening of financial conditions and a deeper recession.
In 2018, the Italian confrontation with the EU probably cost around 0.1% to 0.2% of eurozone GDP. However, a larger sovereign crisis, like in 2011, could easily cost up to 3%.
What does this imply for our asset allocation?
Clearly there is a lot of uncertainty in the immediate prospects of the Eurozone. Depending on the outcome of the events listed above it might lead to a recession or indeed the region might grow well above trend.
In general the most prudent approach in this binary environment, is to reduce the impact of single events by ensuring sufficient diversification over asset classes, regions, sectors and other factors. On investments which are exposed to Eurozone growth, we demand a risk premium, such that we have a margin of safety if things do take a turn for the worse. And finally, we keep a close eye on the political developments, evaluate potential financial impact and dynamically adjust the portfolio as the circumstances change. Carefully balancing risk and return every step of the way.