NEWS Release - Euro Area: Economic Outlook and Financial Sector Challenges - Speech by Vítor Constâncio, Vice-President of the ECB, at the 19th Euro Finance Week: Opening conference - Frankfurt am Main, 14 November 2016
It is with pleasure that I take part again in this year’s opening conference of the Euro Finance Week in Frankfurt. One year on, with another round of unconventional monetary policy measures introduced, the situation has changed for the better but some challenges persist and new risks have emerged.
World economy faces once again an abnormal degree of uncertainty. The consequences may not be immediate. The markets’ perception that the U.S. is embarking into a new phase of expansionary budgetary policy has lifted optimism, with visible effect in financial markets last week. Markets are driven by the insight from the macroeconomic theory that fiscal stimulus, at this stage of the cycle, can break the liquidity trap that has hampered growth in the advanced economies.
Consequently, we saw a beginning of a shift from bonds to equities last week. In spite of their rich valuations in the U.S., equity prices jumped whereas bond valuations worldwide lost close to 1 trillion euros. These movements result from the understanding that fiscal stimulus will increase growth and inflation down the road, in turn allowing a normalisation of U.S. monetary policy at higher interest rates. Anticipating this development, markets sold bonds thus leading to an increase of medium to long-term yields, steepening the yield curve, which is a positive development for financial institutions’ profitability. This expectation was indeed reflected in their share prices amid the general increase of stock valuations last week.
Many commentators have hasted in concluding that the recent geo-political developments will have, after all, economic benefits. This may be the case in the short-term but the real negative effects of heightened uncertainty can come later. We should be cautious in drawing hasty, positive conclusions from those market developments because they may not necessarily indicate that the world economy will have an accelerating recovery with higher growth. So far, those developments point to a U.S. rise in economic growth, but in the context of an “America first” policy. Three factors may contribute to mitigate or even reverse its international spillovers.
The first is the possibility of rising protectionism - hard or soft - that can substantially reduce the effect of higher growth into higher U.S. imports. World trade, already quite weak, may continue to collapse, hurting all open economies dependent on exports.
The second are the negative effects that we are already witnessing in emerging market economies (EMEs). In fact, significant capital outflows and exchange rate depreciations already underway can hinder future growth. Protectionist measures directed particularly against large emerging economies may further decelerate world economic growth and create instability in foreign exchange markets.
The third factor concerns Europe. In this first wave, Europe apparently benefited from positive contagion with some increase in equity prices and a steepening of the yield curve, favouring financial institutions. As concerns equities, the low starting point seems favourable for European markets. Share price levels are relatively subdued in Europe with, for instance, a Cyclically Adjusted Price Earnings (CAPE) Shiller index of just 14 against 27 in the U.S. This means that European shares, including those of banks, are undervalued with respect to other parts of the world and could thus attract investors. However, we already observed a slight drop in European share prices last Friday. According to market analysts, this was explained by fears concerning protectionism and EMEs’ growth prospects as well as the possible resulting decline in global trade.
Besides these external concerns, Europe’s internal problems may deter it from fully reaping the benefits from the expected expansion in the U.S. Indeed, a range of political risks may induce economic shocks. To face heightened world uncertainty, Europe would need to deepen its unity and integration, relying more on its domestic market to underpin higher growth. In turn, this implies that Europe needs more expansionary macroeconomic policies and more reforms in the regulatory and competition policy fields, in order to improve the economy’s supply side. Without higher real and nominal economic growth, Europe will have greater difficulty in overcoming its challenges.
Euro area outlook
So far, monetary policy has been the only expansionary macroeconomic policy in support of the recovery. Yet, securing sustained economic growth and employment cannot be dependent on monetary policy alone. At the national and European levels, a much more comprehensive policy response, than has been the case to date, is needed. Mainly, structural reforms and fiscal policy have yet to deliver their share to support economic activity and counteract the “low growth trap” dynamics faced by advanced economies at present.
The euro area recovery is continuing its moderate but steady pace, supported by the ECB’s policies. These have significantly improved financial conditions, reduced financial fragmentation and fostered economic activity and inflation.
In the first half of 2016, the euro area grew at an annualised rate of 1.7%, similar to last year’s growth rate. This figure is far from impressive, especially considering that the euro area is in the early phase of a recovery, after the second recession in 2012 and 2013. On the other hand, the unemployment rate, albeit falling, still remains above 10%, amid a continuous increase in the participation rate in the labour force since the crisis. One positive aspect is that our policies have contributed to a decrease in financial fragmentation and that the dispersion of GDP growth and inflation across euro area countries is at the lowest level since the beginning of monetary union in 1999. Another positive note is that the recent growth was largely driven by domestic demand. Moreover, the recovery has proved resilient to a series of adverse shocks over the past year: the slowdown in China last summer, the acute stock market turbulence in the early part of this year and, most recently, the uncertainty created by the U.K. referendum.
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