While growth has been slower than many anticipated at the start of 2024, it seems likely that some of the headwinds will fade.
Introduction
At the start of 2024, we were optimistic about Europe’s recovery. Still-strong nominal wage growth and lower inflation were leading to real income gains, which we hoped would support confidence and consumer spending. Manufacturing was expected to see some relief from lower gas prices and a turn in global demand for goods. We also expected an acceleration in disbursements from the Recovery Fund to support aggregate demand.
To date, however, the recovery has proved a little tepid. Consumers remain somewhat hesitant to spend, and the manufacturing sector is still in the doldrums. Recovery Fund disbursements have picked up, but remain behind the pace anticipated in European Commission plans.
Looking forward, however, we do not think the rebound is over. While the manufacturing sector still faces structural headwinds, fading inflationary pressures should prompt faster rate cuts from the European Central Bank (ECB). These would provide a cyclical boost for interest rate-sensitive eurozone corporates and would encourage consumers to spend as their real incomes grow. Meanwhile, a faster pace of Recovery Fund disbursements would help offset gradual fiscal consolidation in some of the eurozone’s more indebted economies.
The eurozone economic recovery has been slower than anticipated
European growth has picked up this year. Over the first half of 2024, the eurozone economy expanded 0.5%, compared to 0.2% over the whole of 2023.
But recent activity indicators have demonstrated that the recovery remains a little slow. Business surveys such as the Purchasing Managers’ Indices (PMIs) suggest muted growth, with manufacturing a particularly large drag. Indeed, industrial production has fallen 3% from end-2023 levels, driven by weakness in energy-intensive sectors. This lukewarm economic backdrop reflects a slower-than-expected pick up in consumption, alongside headwinds for goods producers and some challenges in accessing Recovery Fund money.
Timid consumers
One factor behind the tepid eurozone recovery has been a timid consumer. While consumer confidence and spending have risen over the course of 2024, the pace of increase has been modest. Incremental real income gains have increasingly been saved, rather than spent. Indeed, the eurozone-wide savings rate sat well above its pre-pandemic average across the first half of 2024.
Still-elevated interest rates have likely played a role in encouraging saving over spending. Indecisive national and regional election results, as well as ongoing geopolitical tensions, may also be weighing on consumer sentiment.
Alongside this, European consumers store a meaningful part of their wealth in deposits, the real value of which has been eroded by higher inflation over the past few years. This negative wealth effect has been compounded by a slight decline in house prices over 2023.
Looking forward, however, we think some of these headwinds should fade. Lower interest rates are likely to aid consumer confidence and incentivise spending, and real incomes continue to grow. The fourth quarter Bank Lending Survey showed household loan demand is already picking up fairly meaningfully. In particular, the net percentage of banks reporting an increase in mortgage demand rose to +39, suggesting a eurozone housing market recovery may already have begun.
Manufacturing malaise
The European manufacturing sector is where current weakness looks most acute. For example, the eurozone manufacturing PMI sat at a preliminary 45.9 in October, signalling ongoing contraction.
One factor behind this weakness is elevated financing costs. Eurozone corporates are especially sensitive to interest rates: 70% of European corporate financing is provided by banks, compared to just 27% in the US. The capital-intense manufacturing sector is feeling the pain of currently tighter financial conditions more than most, given its greater dependence on borrowing.
Elevated wholesale energy costs in Europe are further challenging the competitiveness of European manufacturers. European gas prices remain more than four times US levels. Given this, eurozone industrial production remains weakest in energy-intensive industries such as chemicals, steel, and autos.
Compounding the problem, European manufacturers are facing intense competition from Chinese firms. The Chinese government’s export-oriented growth strategy and Chinese firms’ cheaper production costs make it difficult for European manufacturers to compete on price. This has led to weakness in manufacturing exports, and a shrinking market share for European firms within the European Union (EU).
Finally, weaker goods demand has also hindered European manufacturing. Global consumers have remained reluctant to spend on durables after a pandemic-era boom in goods demand. Indeed, eurozone firms now cite demand as the biggest constraint on their production.
The European autos sector is at the epicentre of current manufacturing weakness. While global car production is stable, it has been declining in Europe, and EU new car registrations remain below pre-pandemic levels. Sales of internal combustion engine (ICE) cars, where EU producers have typically specialised, are falling, whereas electric vehicles (EVs) have risen from 14% of new car sales in 2022 to 18% in 2023. Problems are particularly acute in Germany, where the autos sector makes up over 4% of the economy – much higher than the 1.6% eurozone average.
Some of the pressures facing European autos firms, and manufacturers more generally, are due to EU legislation. The European Commission is currently mandating that all new vehicles be zero-emission by 2035. European auto firms are therefore attempting to shift production towards EVs, but are struggling with high battery costs. This makes European-produced EVs significantly more expensive than European ICE vehicles, in contrast to China where EVs are cheaper than their traditional counterparts.
The EU is taking steps to address the challenges facing European automakers. For example, the import tariff on Chinese EVs was recently raised to 45%, which may help level the playing field somewhat within Europe. But given the lower production costs and government support enjoyed by Chinese auto firms, even this move may not fully correct the price differential between European and Chinese EVs.
Thus, Europe’s structural competitiveness problems look set to persist under current legislative plans. Tariffs do not tackle the price differential between European manufactured goods and those produced elsewhere in third country markets, and will not work to lower energy costs or improve global goods demand. The EU is not yet showing a willingness to ease its regulatory standards or provide support to European automakers trying to compete globally.
Looking forward, however, the manufacturing backdrop is likely to improve on the margin. Upcoming interest rate cuts will provide meaningful relief to a sector currently hindered by very elevated financing costs. Indeed, the fourth quarter Bank Lending Survey showed a positive turnaround in corporate loan demand to finance fixed investment. Alongside this, recent demand-side stimulus from the Chinese government could also boost Chinese demand for European goods.
However, European manufacturing firms will still face structural challenges driven by their lack of price competitiveness. For a stronger improvement in the manufacturing outlook, we would need to see a more pronounced uplift in the global goods cycle, a structural decline in European energy costs, or greater willingness from European policymakers to try and level the playing field.
Stimulus disappointment
Alongside a slower consumption recovery and weaker manufacturing sector, disbursements from the Recovery Fund – the EU’s post-pandemic fiscal support programme – have not accelerated meaningfully. Several EU member states have struggled to rapidly implement the projects and reforms required to unlock the funds available. This slower implementation has been driven by cost pressures, labour and material shortages, and unanticipated bureaucratic hurdles.
Alongside this, the European Commission placed some member states – including France and Italy – into its ‘excessive deficit procedure’ in July, limiting their room for fiscal manoeuvre.
In 2025, the Recovery Fund will continue to provide fiscal support to European growth, or help offset gradual fiscal consolidation in member states subject to an excessive deficit procedure. Implementation may pick up as cost pressures and labour shortages fade. Around €380bn of the fund remains to be disbursed, which if spent by 2026 could increase eurozone GDP by 1.5% according to ECB staff.
Additionally, some member states are asking the European Commission to extend the timeframe of Recovery Fund beyond 2026, making it more likely that the fund’s grants would be fully spent. Such an extension would require unanimous approval from member states, but would prolong the period of fiscal support available under the Fund.
The prudent EU fiscal framework of excessive deficit procedures and debt reduction plans stands in stark contrast to the US. Whether investors reward this prudence with lower bond yields – which in turn provide a compensating stimulus – remains to be seen. If not, US fiscal largesse may continue to contribute to a growth differential versus the eurozone.
Conclusion
We do not believe the eurozone recovery is over. While growth has been slower than many anticipated at the start of 2024, it seems likely that some of the headwinds outlined above will fade.
Faster interest rate cuts from the ECB, driven by moderating inflationary pressures and slower-than-forecast growth, should provide some relief to manufacturers and support consumer spending. While other headwinds for goods producers may persist, ongoing real income growth should also continue to gradually boost confidence and consumption. And deployment of Recovery Fund cash will bolster aggregate demand, especially in countries gradually consolidating national budgets.
Thus, although European activity may have been a little disappointing over the majority of 2024, there remain reasons for positivity looking forward.