By T. Rowe Price European fixed income portfolio manager Kenneth Orchard
After years of economic stagnation, the gradual recovery in the eurozone is beginning to show signs of sustainability.
Extremely supportive policy and favourable developments all bode well for the region in 2016. The outlook is not without risks however, with political uncertainty chief among them.
We believe the following six factors will have a strong influence on markets in 2016.
Economic growth: Continuing, albeit modest
The pace of economic growth during the first half of 2016 is likely to remain unchanged from that of 2015. Over the past year, domestic demand has gained ascendancy as the main growth driver in almost all eurozone countries.
Employment is rising, which is positive for domestic consumption and encouraging for the cyclical recovery – while fiscal policy also remains supportive for domestic demand. Lower oil prices are similarly flowing through to domestic spending.
Economic divergence between countries will again be a feature. Countries with more competitive economies, stronger budget positions, and lower debt burdens are expected to grow at above the eurozone average rate. The largest of this group is Germany, along with the Netherlands, Latvia, Lithuania, and Slovakia.
In addition, Ireland, Slovenia, and Spain are also likely to outperform. Conversely, France and Italy are likely to grow at below-average levels. Despite implementing some important economic reforms, both countries have much to do in order to restore competitiveness, compared with eurozone peers.
Fiscal policy: Some room for flexibility
We expect another year of marginally looser fiscal policy, as austerity is again put on hold. In most eurozone countries, 2016 budgets factor in at least some measures aimed at stimulating the economy. Of course, any fiscal stimulus has negative implications for structural budget positions, given it generally means taking on additional debt.
As in 2015, significant differences in the fiscal positions of individual governments will be a feature. However, we do not see the market being overly concerned about debt sustainability. Despite still moderately high budget deficits, the current pace of economic growth, along with low interest rates, should be enough to at least stabilise public debt ratios in most countries.
Monetary policy: To remain extremely loose for longer
The sole policy objective of the ECB is to keep inflation at just below 2%. Currently, it forecasts inflation to be only at 1.6% by the end of 2017. This has put the ECB under considerable pressure to maintain an extremely loose policy framework in the hope of driving inflation closer to target.