Regional Outlook: Europe

The outlook in Europe has improved with both the Eurozone and UK emerging from a recession, as growth surprised to the upside in the first quarter of this year. Improved sentiment is being supported by several factors, which are set to continue into the second half of the year. Inflation has normalised since the start of the year, while labour markets across Europe remain relatively tight with wage growth elevated. This will mean a gradual recovery in real incomes for households over the second half of this year, which should support consumer spending.

Growth across Europe’s regions has diverged since the pandemic, southern Europe is on course to grow faster than the north again this year, driven by higher tourism spent and ongoing support from EU funds. Tourism activity was robust in Q1 2024 as southern Europe saw a significant increase in visitor numbers compared to pre-pandemic levels at similar time of the year. Momentum is likely to carry over into the summer as conflict in the Middle East could draw more demand to European tourist destinations. Southern European economies are also among the largest recipients of Next Generation EU funds which have been a key source of investment spending on infrastructure and energy. This is set to continue this year with the European Commission expecting to release an estimated EUR100 billion in 2024, the bulk of which is expected to be spent in southern and eastern Europe.

Robust economic activity in the south contrasts with the north where the manufacturing sector accounts for a larger share of output and continues to suffer from the impact of the energy shock and weaker external demand from China. Public investment has also been weaker, particularly in Germany where spending has been constrained by the country’s stringent fiscal framework.

Fiscal policy is likely to become a headwind for growth not just in Germany this year as several EU countries, including France and Italy look set to be in breach of the newly agreed EU fiscal rules, both countries on course to run budget deficits significantly above the 3% limit this year. The European Commission estimates that debt interest payments in Italy will rise to 4% of GDP this year, highlighting the urgency to tighten fiscal policy.  

The European Central Bank began its loosening cycle in June, cutting interest rates ahead of the Federal Reserve and the Bank of England. Inflation has moderated since the start of the year, although underlying inflationary pressures remain elevated. Wage growth came in above the ECB’s expectations in Q1, but forward-looking indicators point to a slowdown over the coming months. The pace of cuts from here onwards will be dependent on whether the ECB sees risks of a re-acceleration in inflation, particularly as gas prices have rallied since the start of April. The doves may argue that the ECB has room for manoeuvre, as even a cut in July will keep interest rates firmly in restrictive territory. On the other hand, the hawks may point to the Eurozone’s return to growth in the first quarter coupled with recent stickiness in services inflation as reasons to remain cautious. Christine Lagarde has stressed that the ECB will be data dependant and it will be likely that consensus to cut on the Governing Council will only be reached when new staff projections are published. We expect the ECB to cut twice more this year, in its September and December meetings, taking its key interest rate down to 3.25% by the end of 2024.