Massive economic shock
Economic data have confirmed the scale of the shock from the shutdowns to contain the coronavirus. Eurostat reported that eurozone real GDP fell by 3.8% in the first quarter, with notable weakness in France, Italy, and Spain. Manufacturing and services PMIs plunged in April and recovered only modestly in May. Manufacturing activity in the eurozone is now as weak as it was following the global financial crisis. Service sector activity has dropped to historic lows, implying GDP could fall by 10%-20% in the second quarter.
With a partial reopening of the eurozone economy, most forecasters expect a recovery in the second half of 2020. Even so, we are unlikely to see a full return to pre-virus activity levels as forecasts show the eurozone’s GDP shrinking by 8-10% in 2020 before rising by 4%-6% in 2021.1
Financial markets aren’t discounting break-up risks
For optimists, the huge economic shock of the coronavirus shutdown has exposed the limits of the eurozone's policymaking institutions and may force politicians to make changes, with the establishment of a fiscal union to support the monetary union. For pessimists, the scale of the economic shock could trigger an existential crisis for the eurozone and the wider EU, leading to fragmentation and perhaps even the collapse of the entire project.
The European Commission recently proposed a €750 billion recovery fund to support those countries most badly affected by the pandemic. The 27 member states will now have to agree on the details of the fund, which could take some time. But with strong support from Germany, which is prepared to make a substantial financial contribution, the fund could mark an important step towards closer integration in the eurozone and the wider EU.
Higher equity risk premiums in Europe suggest that investors are still wary of economic prospects and the potential stability of the eurozone. But a fading tail risk of fragmentation could help to reduce equity risk premiums in Europe’s main markets.
1GDP: Gross domestic product. Source: DG ECFIN European Commission