Europe: Clouds are slowly lifting

The end of the recession does not mean that Europe is set for a regular cyclical recovery. It will take a long time before the debt overhang, which has been at the heart of the crisis since 2008, is gradually reduced to sustainable levels, and this will represent a major drag, at least for the next two years.

We still see downside risks dominating for 2014, in particular owing to the short-term consequences of the upcoming asset quality review of euro area banks and possibly difficult discussions regarding financial assistance to Greece and Portugal. However, risks should rebalance in 2015; in particular, the rebound in investment could be more pronounced than we envisage.

Banking Union has been progressing over the past three months, with the launch of the Single Supervision planned for November 2014. However, divergences on the second pillar (the Single Resolution Mechanism) were still unresolved at the time of writing, and the discussions with the European Parliament at the beginning of 2014 will be complicated, especially since the compromise that is likely to emerge from the Council represents a significant downgrade of the initial proposal. We think that a failure to adopt a solid and efficient SRM would extend the negative effect of financial fragmentation into 2015.

Inflation has dropped all around Europe during the autumn, with the weakness now broad based across countries and sectors. We believe that inflation will remain very low for an extended time, and we see risks tilted to the downside, especially in the euro area, as the internal devaluation is actually adding to the deflationary pressures. A low inflation environment is making fiscal consolidation more difficult and solvency more distant for several countries

Central banks are likely to keep interest rates unchanged for a long time. The BoE is unlikely to raise rates before 2016, as risks around the inflation knockouts are low. We expect the ECB to maintain its policy rates at current levels, but the likelihood of further action has increased, given the weak inflation outlook, strong euro and anaemic credit growth. We expect a “conditional LTRO” or a funding-for-lending scheme to be deployed in H1 14. Should the downside risks to growth and inflation materialise, we think a securities purchase programme and/or a rate cut cannot be ruled out.