Eurozone: a second recession, but with a silver lining

The Eurozone economy started the year on a weak footing as the third wave of coronavirus infections forced governments across the block to tighten restrictions. The economy contracted -0.6% q/q in the first quarter, pushing the Eurozone into its second, albeit much less severe, contraction within one year. This is slightly worse than the –0.4% q/q we had penciled-in, mainly due to Germany. Based on the available data for the large Member States it seems that both domestic demand and net exports have contributed negatively. When comparing the large Member States, Germany has clearly performed worst, declining by 1.7% q/q, while France managed to grow with 0.4% q/q as we had forecasted. For more details on the performance of individual Member States, please see below.

Going forward, with the inoculation rate picking up (23% of the EU population has had at least one shot and 8.4% is fully vaccinated), the correlation between hospitalizations and infection rates falling, and increasing pressure from businesses and households to reopen the economy, governments are gradually loosening the reins – or at least planning to. This should clearly give a boost to activity in the services sector, which already showed some signs of stabilization in April (figure 2), albeit at very low levels. Meanwhile, the gradual easing of restrictions should also benefit the industry sector, with manufacturing and exports also set to benefit from improving world trade (figure 3).

That said, production in certain sectors such as the automotive industry is expected to continue to be hindered by the global shortage of semi-conductor chips, whilst lengthened delivery times and increased input costs pose other risks to the manufacturing sector’s outlook (figure 4). Higher production costs have already translated into higher consumer prices. If wages do not follow –and we don’t expect them to– this could dampen demand going forward. Furthermore, restrictions in multiple countries have still been harsh this month, while the health situation remains very precarious, which warrants caution in the short term. Infection rates continue to be very high throughout the block –and even increasing in for example Germany and the Netherlands– with overburdened ICUs in multiple regions.

All in all, we project decent growth in the current quarter, but an even stronger recovery in the second half of the year as it will take until summer before containment measures can be lifted at large. Thereafter the pace of recovery will soften and we expect it will take until mid-2022 for GDP to return to its pre-crisis level. Note that this baseline hinges on the assumption that economies can largely reopen by summer and enjoy a decent tourism season. Several countries are cautiously moving in this direction (see e.g. France, Spain and Italy). If reopening is delayed beyond the summer, we expect the recovery to pre-COVID levels to be delayed by approximately three quarters.

Our economic projections include the support of the EU Recovery and Resilience Facility (RRF), which comprises EUR 312.5bn in grants and EUR 360bn in cheap loans (in total some 5% of EU27 GDP). Today is the deadline for Member States to present their ‘final’ Recovery and Resilience plans to the European Commission (EC). At the time of writing, 18 out of 27 Member States, including Germany and France have done so, while others, such as Italy and Spain will do so today. And some countries, like the Netherlands, are sure to miss the deadline. Unsurprisingly, the presented plans include large amounts of planned investments for greening and digitalizing the economy. The European Commission required Member States to devote at least 37% of the funds on climate investments and reforms and 20% to foster the digital transition. Buzz words reappearing in multiple plans include electric vehicles, hydrogen research and digitalization of public services and that of SMEs. On top of that, countries tend to focus on their specific challenges such as the North-South and Old-Young divide in Italy. Remember that apart from meeting investment targets, countries will also need to reform inefficiencies currently impeding higher growth. Promised reforms range from tackling bureaucracy and inefficient public administrations, labor markets and justice systems to promoting competition, tax reforms and the sustainability of pension systems.

Timeline and impact

The European Commission now has the questionable honor to dig through thousands of pages of plans in the coming two months to determine whether they meet the criteria. Thereafter, the Council, has one month to give its consent, or reject to do so. If all goes well, the first funds should start to flow from July. Yet for that to happen, it is also essential that the Own Resources Decision, giving the green light to the EC to start borrowing money to fund the facility, is approved by all Member States before then. At the time of writing, 8 Member States still need to sign off. While that timeframe sounds challenging, it is not impossible. More importantly, in our view, a few months delay would probably not have a major economic impact.

Remember that apart from pre-financing of at most 13% this year, disbursements will depend on reaching spending and reform milestones. Based on experience with the absorption of ‘usual’ European Structural and Investment Funds (ESIF) of the EU budget, it is likely that national capitals will need time to absorb the massive amount of money available through the RRF. The total amount available is about 1.5 times the size of the 2014-2020 ESIF. Moreover, reforming institutions has proved difficult for many governments, both due to technicalities and vested interests. On the bright side, experience with the EU support programs during the Eurozone debt crisis, has showed that in many cases rewards for reforms tend to stimulate governments – at least it has in Spain, Portugal and Ireland.

Against this background, in a first attempt to calculate the impact of the EU recovery fund we come to a cumulative GDP impulse of 0.5% over this and next year. The impulse will increase in the years beyond our forecasting horizon, as (i), as mentioned, absorption of the funds by national capitals will take time; (ii) the multiplier of investments will likely grow over time as they improve the productive capacity of the economy via increased skill sets and new technologies; and (iii) it takes time for reforms to bear fruit. For more detailed explanations about the calculations and assumptions please see here for Italy and Spain.

On the back of a tightening of virus-related restrictions in the retail and hospitality sectors, the sharp slowdown in German economic activity proved to be a large drag on the Eurozone economy. The total volume of output contracted by 1.7% q/q in the first quarter of 2021, a significantly weaker result than we initially expected (-1.0%). And even as the German statistics office revised its estimate for the preceding quarter higher to 0.5%, this ‘double dip’-recession leaves the German economy nearly 5% smaller than before the pandemic struck.

The statistics office will publish a more detailed breakdown on May 25, but a variety of indicators indicate that the slowdown has been relatively widespread. The services sector is directly affected by the tightened restrictions to curb the spread of the virus, the construction sector has had a particularly difficult February due to harsh winter conditions, and manufacturing industries suffered from ongoing supply chain disruptions and, on top of that, the reversal of some Brexit-induced stockpiling.

Even as the recovery from the pandemic still has a long way to go, the outlook is fairly benign. The good news is that the pace of vaccinations has picked up markedly over the past couple of weeks. This Wednesday alone, Germany administered just under 1.1 million Covid-19 shots. Barring any (new) setbacks, a reduced pressure on the health care system would allow some easing of restrictions over the course of May and June. This gradual reopening of the German economy would then coincide with strong foreign demand, from China and the US in particular. The manufacturing PMI continues to point at strongly elevated (export) order books. Even as ongoing shortages in key components continue to disrupt production in the near team, it is clear that the upturn has plenty more room to run.

French GDP grew 0.4% q/q in the first quarter of the year, which was roughly in line with our estimate. Net foreign trade made a negative contribution –as exports contracted more than imports– but domestic demand contributed positively. However, consumption (0.3% q/q) rebounded only mildly from the sharp contraction in Q4 (-5.7%), when a new lockdown was enacted. This slower-than-anticipated rebound relates strongly to the inability to spend: closed restaurants, bars and shops will have weighed on consumer spending.

Going forward, the planned gradual relaxation of restrictions –if not foiled by a renewed surge in COVID cases– should provide some further support to consumption. That said, this recovery of consumption will likely be gradual, considering that capacity in stores remains limited and that the hospitality sector will probably only see limited catch-up demand. This Monday, schools have reopened, and President Macron plans to ease the curfew and reopen shops and terraces with limited capacity by mid-May. If all goes well, reopening of cafés and restaurants should then follow in early June.

Apart from improving domestic demand, foreign trade should also provide support to the French recovery, after its negative contribution in Q1. While the first quarter’s performance was partially driven by sector-specific factors, it likely also related to the renewed lockdowns in France’s trading partners through Q1. These are expected to be loosened in the coming weeks.

Italy’s GDP contracted with 0.4% q/q in the first quarter of 2021, in line with our expectations. Expenditure components show that net exports were the main culprit of the contraction, depressing growth, while domestic demand contributed positively. Looking at sectors, value added in agriculture, industry and construction grew, while it shrank in the services sector.

Going forward, the economy should return to growth in the current quarter, despite the strict limitations in place in hospitality and retail during the first half of April. By now very few regions are still facing ‘full’ closure of hospitality (12%) and retail (2%) venues and there will be even less from next week. At the same time, theatres, museums and cinemas have reopened in 85% of the country, with more regions to follow next week. This should give a welcome boost to the services sector, while the important manufacturing sector will benefit from both the improving domestic and external environment. Certain restrictions remain in place though, like constraints on capacity and indoor dining. These are expected to be largely removed towards the end of the quarter, providing ample scope for recovery in the summer months.

Spain’s GDP contracted with 0.5% q/q in the first quarter of 2021. A resurgence of the virus forced the national and regional authorities to strictly tighten containment measures early in the quarter. That said, a bit earlier than expected measures were again being eased, providing scope for improving activity towards the end of the quarter – which likely is behind the stagnation rather than contraction in the services sector. Expenditure components show that domestic demand contributed negatively and net foreign demand positively. Imports contracted much more (-1.3% q/q) than exports (-0.1% q/q), despite the weakened environment in important trading partners.

Going forward, we project the recovery to resume this quarter on the back of loosened containment measures, the vaccination pace gaining speed and the improving international environment. Decent growth this quarter will then be followed by a more pronounced recovery in the summer months, when the economy is expected to be largely reopened.