European Industrial Outlook: Recovery Picking Up Speed

Summary of Findings and Forecasts

  • Domestic demand has emerged as the decisive driver of economic activity in the EU. Even as the euro weakened over the course of the year, feeble demand in emerging markets put a brake on European exports.
  • With the Greek crisis temporarily on hold and the cost of capital low, business confidence is up. We forecast a marked acceleration in spending on business equipment and a moderate uptick in construction outlays in 2016 and 2017.
  • Manufacturing activity is growing at a slower pace than that of services; however, key business confidence indices point toward a much faster pace of industrial production growth that should end 2016 about 2% higher.
  • Virtually the entire continent is now growing, although regional differences persist. Ireland, Sweden, Spain, and the UK have emerged as the locomotives powering ahead, with annualized GDP growth exceeding 2%.
  • Among the large emerging economies, Romania and Poland lead the pack with rates upward of 3.5%. German GDP growth will come close to topping 1.5% this year and 2% in 2016 and 2017 but France will underperform these rates by at least half a percentage point during 2015-2017.
  • Risks to the baseline scenario include a possible breakdown of consensus on refugees, Russia, TTIP, China, or the Middle East, which would sap investment confidence. The re-emergence of the Greek default is simply a matter of time; the country’s debt sustainability problems have not been solved but merely pushed aside for political expediency.
  • There are signs that the German economy is nearing its full capacity to grow. Construction has taken a breather over the past half-year after four quarters of intensive growth.
  • After painful recessions and a banking crisis, Spanish economic growth will be just over 3% in 2015 and upward of 2.5% in the two subsequent years. Construction activity is leveling off amid signs that supply is catching up with strong demand.
  • French manufacturing is treading water. Recent reforms mostly targeted the labor market and their impact on corporate spending and hiring will take time. Meanwhile, the weaker euro is not translating into permanently higher exports.
  • Poland is defying expectations of an imminent slowdown. GDP is now slated to advance 3.5% in the next two or three years. A cloud to an otherwise bright outlook comes from the labor market; employment is slowing while the jobless rate is coming down only reluctantly.

Cyclical Overview
Economic growth remained buoyant in the second half of the year, if somewhat slower than in the first half. Domestic demand has emerged as the decisive driver of economic activity. Even as the euro weakened over the course of the year, feeble demand in emerging markets, combined with their falling currency rates, put a brake on European exports. At the same time, EU consumers are slowly freeing up their purses and spending more. With the Greek crisis temporarily on hold and low cost of capital for the foreseeable future, business confidence is up. We forecast a marked acceleration in spending on business equipment and a moderate uptick in construction outlays in 2016 and 2017. GDP should rise just below 2% in each of the next two years.

Virtually the entire continent is now growing, although regional differences persist. Ireland, Sweden, Spain, and the UK have emerged as the locomotives powering ahead, with annualized GDP growth exceeding 2% in Western Europe. Among the large emerging economies, Romania and Poland lead the pack with rates upward of 3.5%. At the other end of the spectrum, business cycles in Finland and Greece are posting uneven activity; even though both countries have recently emerged from recessions, capital formation continues to shrink, depressing income. German GDP growth will come close to topping 1.5% this year and 2% in 2016 and 2017 but France will underperform these rates by at least half a percentage point during 2015-2017.

Manufacturing activity is growing at a slower pace than that of services; however, key business confidence indices point toward a much faster pace of industrial production growth in the months ahead. In the absence of a substantial uptick in capital formation (which should, however, advance in 2016), output of selected consumer goods singularly supports the industrial sector at the moment. Looser lending standards, combined with a promise of low interest rates for months to come, offer a strong incentive for companies to invest. The manufacturing sector will record strong overall growth of 1.6% for 2015 above a low base the year before. Performance should improve further in the following year on the strength of more robust capital formation—we expect manufacturing production to top 2% in 2016.

The industrial outlook has brightened since our July report. Geopolitical tensions have abated somewhat, although the influx of refugees added turmoil to the already strained cohesion within the EU. Business investment is on the cusp of a takeoff that will bolster industrial production and consumer income beyond 2016. Central Europe and Ireland will see their manufacturing sectors expand upward of 5% this year. Longer term, there is room for industrial production to pick up another 3-4 percentage points before capacity constraints bump in. Any upside in Central Europe is conditional on Western European demand growing, however, which in turn is constrained by extra-EU exports.

What can go wrong with this scenario? On the political side, a crisis within the EU (caused, say, by a breakdown of consensus on key policies, such as refugees, Russia, TTIP, China, or the Middle East) would sap investment confidence and hence the pace of capital formation. On the financial side, banking turmoil cannot be excluded, as several countries have swept their banking woes away from public view. A pan-European resolution fund remains underfunded, which means that any rescue burden would largely fall on national treasuries. Finally, the re-emergence of the Greek default is simply a matter of time; the country’s debt sustainability problems have not been solved but merely pushed aside for political expediency. When it resurfaces, it might be more difficult for the EU to find a consensus on debt write-offs in the face of mounting disagreements on refugees and political pressures from Eurosceptic parties.

Industries in the Current Business Cycle
In Figures 2 and 3, industrial sectors are positioned along a cyclical path divided between phases of growth and decline. Central Europe is made up of the Czech Republic, Hungary, and Poland.

  • Less than a third of the sectors in the Eurozone are still in recession (compared with half six months ago). We expect more industries that are now in the early stages of a recovery to move to a mature phase of the cycle.
  • In Central Europe, most sectors are now in a mature phase of the cycle and will likely remain there in 2016.

Regional Analysis

Belgium (Figure 4)

  • Domestic demand remains feeble as several tax measures put a brake on capital formation and consumer spending. Net exports will drive growth in 2016 but capital formation should accelerate late in the year and into 2017. Overall growth will almost top 2% in 2017, when the economy is slated to fire on all cylinders and unemployment should inch down below 8%.
  • Manufacturing output is expanding, although at a moderate pace. Terms of trade have already improved with rising inflation and they will translate into a modest but stable current account surplus. By contrast, construction has been treading water for more than a year now, depressed by the lack of business investment and previous waves of overbuilding. Overall industrial production will accelerate to 2% in 2016 and about a percentage point higher the following year.
  • Several process industries are taking off on a faster growth trajectory. Among them are foodstuffs, wood and paper, and rubber and plastics (driven by external demand for construction services) as well as a few durables categories. The latter include fabricated metals, which are driven by construction demand in Germany.

Czech Republic (Figure 5)

  • The Czech economy has temporarily overtaken Poland as the regional growth tiger. Propelled by one-off effects of heightened EU-financed investment in infrastructure, GDP will have topped 4% in 2015 before sliding to the 2-3% range in the subsequent two years. Growth will shift to consumption, private capital formation, and exports in 2016.
  • Manufacturing is on an upswing. Investment spending is booming and consumers are flush with extra income that they are happy to splurge on purchases. Industrial output is advancing at a 6+% clip, about the same as construction activity.
  • The expansion continues to be broadly based. The best performers are sectors tied to infrastructure spending, such as nonmetallics, fabricated metals, and machinery—all growing at about a 9% clip. Output of autos has been expanding at a 10% rate for about a year now and will accelerate somewhat in 2016 on the strength of the Eurozone recovery.

Germany (Figure 6)

  • There are signs that the German economy is nearing its full capacity to grow. Employment continues to grow amid a faster increase in nominal and real (inflation-adjusted) income and a falling jobless count. Business confidence has risen continuously for several months and is near recent peaks. GDP growth is expected to be just under 2% in the next two years.
  • The manufacturing sector is leveling off amid still lackluster domestic investment demand and weakness in the core export markets of the Middle East, Russia, and Asia. We expect Germany to underperform Spain and Sweden in manufacturing output growth in 2016 but outperform France and the UK.
  • Construction has taken a breather over the past half-year after four quarters of intensive growth. There are no stellar industrial performers at the moment, but demand for heavy equipment gear is slated to perk up in 2016 and grow particularly robustly in 2017 when capital formation hits full swing.

Spain (Figure 7)

  • Spain’s recovery has surprised on the upside in 2015. After painful recessions and a banking crisis, economic growth will be just over 3% in 2015 and upward of 2.5% in the two subsequent years. The labor market will stabilize further while the pace of financial deleveraging should ease. Both will give a boost to domestic demand and rebalance the sources of growth.
  • The manufacturing sector is hot. Output was up about 5% year-on-year in the third quarter, driven by strong outlays on business equipment. On the other hand, construction activity is leveling off amid signs that supply is catching up with strong demand. Total industrial production should gain about 3% in each of the next two years.
  • The durables segment is leading the way. Wood, nonmetallics, and fabricated metals benefited from robust construction activity while nearly double-digit gains in electronics and other machinery drew strength from a pickup in investment spending.

France (Figure 8)

  • The French recovery proceeds slowly. Despite only modest gains in household income, consumer spending is up amid a rise in purchasing power and a dip in savings. Recent terrorism should not shake consumer confidence in the long term. Overall, however, GDP growth will be stymied by a tepid pace of capital formation and moderate exports.
  • Manufacturing is treading water. Recent reforms mostly targeted the labor market and their impact on corporate spending and hiring will take time. Meanwhile, the weaker euro is not translating into permanently higher exports. All in all, at 1%, the industrial sector in 2015 will eke out its first annual expansion in four years.
  • As in other European countries, the strongest industrial sector in France remains auto production and its supply chain (e.g., electronics and rubber and plastics). Construction activity is declining in line with a smaller public purse while the residential housing market suffers from tightened credit.

Italy (Figure 9)

  • Italy is gradually making up lost ground following several recent recessions but the pace of recovery is slow. Uncertainty about the health of banks is holding up credit while low inflation is boosting disposable income. Factoring in faltering global demand, GDP will advance at most 1.5% in the next two years.
  • The manufacturing sector is outperforming the rest of the economy, if only slightly. Labor market reforms have spurred some fresh hiring, which should support gains in consumer demand. However, business investment is still flailing despite robust corporate profits. The overall gain in manufacturing output will near 2% in 2016.
  • The country’s auto sector is booming. Selected machinery segments are also growing at above-average rates on the tails of external demand that is set to wind down. Italy’s long contraction in building activity has hit bottom, although it will take years to recover lost ground.

Hungary (Figure 10)

  • Hungary’s boom is coming to an end but with a soft landing. GDP growth is slowing from a rate of almost 4% to 2.2-2.5% predicted for the next two years. Public investment is slated to slow while privately sourced capital formation is taking off only slowly.
  • Public works programs continue to underpin the expansion that is partly underwritten by the EU. Hungary is one of the few countries in Europe with inflation running consistently close to the 2% mark. As a result, despite a slowing pace of growth, further inflationary pressures are likely, and they will put a damper on public spending.
  • Manufacturing is sustaining its robust expansion of about 6-7% in real terms on the strength of a few sectors (e.g., autos and its supply chain). Other industrial segments are in growth mode, although at lower rates of expansion. New investments in the auto sector explain the nearly 20% annual rate of auto production.

Netherlands (Figure 11)

  • The recovery is picking up pace, although not as quickly as expected. Overall, GDP should gain about 2% in 2016 and 2017. The housing boom, evident for the past two years, is now constrained by an income ceiling. At the same time, business surveys indicate that outlays on equipment will accelerate. Finally, the government is set to stimulate demand through loosening the fiscal purse.
  • The recovery is broadly based but the fiscal stimulus will favor the consumer. Employment has already picked up and now tax cuts should beef up disposable income as well. Consumer spending growth should catch up with GDP sometime in 2016.
  • The manufacturing sector is taking a breather that should not last long. The recovery is broadly based, in line with the Netherlands’ large exposure to global markets. There is notable weakness in chemicals that partially stems from structural changes to the locally sourced feedstock.

Austria (Figure 12)

  • The Austrian recovery has been underperforming the EU average for a number of quarters. Exposure to Russia is one explanation but not the main factor. The contribution of net exports has gradually diminished in line with slowing global demand but consumer spending could not make up the gap, owing to depressed sentiment and stagnant wages.
  • Manufacturing faces a bright near-term future. It will be driven by a pickup in investment spending that is buoyed by low capital costs and a more favorable lending environment. At the same time, the weakness in overseas demand will be somewhat compensated by a favorably priced euro.
  • Total industrial output will top 2.5% in 2016 and more in the following year. Austria is the one country where the auto sector is growing at an average rather than above-average rate. We see strength emerging in selected durables, such as metals, machinery, and electronics.

Poland (Figure 13)

  • Poland is defying expectations of an imminent slowdown. GDP is slated to advance 3.5% in the next two to three years—faster than previously thought. One reason is that productivity is unusually robust, supporting higher wages, which in turn stimulate consumption. Capacity is adjusting well to the new wave of EU co-funded investment. On the flip side, net exports will now subtract from rather than add to growth (although the impact will be rather small).
  • A cloud to an otherwise bright outlook comes from the labor market; employment is slowing while the jobless rate is coming down only reluctantly. This caps the potential of the economy to grow faster. If the Russia–Ukraine conflict were to flare up again, this would negatively affect business sentiment.
  • The manufacturing sector is performing well under the circumstances but its growth rate should come down from the 6+% rate to 4.5-5.0% on an annual basis. The sectoral breakdown shows an evenly distributed contribution to overall growth, with autos and various machinery subsectors growing at above-average rates.

Sweden (Figure 14)

  • Sweden’s recovery is picking up speed. Consumers feel comfortable spending amid a low interest rate environment and a wealth effect from high housing prices. At the same time, the investment component is shifting in favor of business fixed investment and away from housing. GDP growth will stay above 2.5% for at least two more years.
  • The manufacturing sector has finally emerged from a three-year industrial recession. Real output will rise at a progressively faster pace and finish 2016 just above the 2.5% mark.
  • Construction continues to be unusually robust but its double-digit growth rate cannot be sustained for much longer. The strategically important wood, pulp, and paper sectors are all in expansion mode after years of painful restructuring. Machinery is experiencing weakness but will gradually turn around once the pace of capital formation picks up speed.

United Kingdom (Figure 15)

  • The British economy is nearing its inflection point, after which GDP growth will slow down somewhat. The economy is near its full potential (meaning that all factors are employed), which will translate into a GDP growth rate of about 2.5% in the next two years. Domestic demand, primarily consumption, will drive growth, with net exports weakening.
  • The manufacturing sector continues its slide from a torrid pace of nearly double-digit growth two years ago. At about 1.5% in 2016, the UK industrial sector is suffering from a strong pound sterling and sagging productivity.
  • Aside from motor vehicles, cyclical strength lies in process industries, such as petroleum refining, chemicals, and wood products, which are variously feeding off the favorable pricing of raw materials. Construction activity has been slowing down for over a year, as earlier waves of infrastructure spending have not been replaced by private sector investment.
Kristin Graybill