2011 will be a crucial year for the euro area. The recovery is on track and is gaining sustainability, driven mainly by the booming economy of Germany, but sovereign debt woes will continue to pose a threat to the growth outlook and to the financial stability within the area. European policymakers and the European Central Bank will have to act consistently and take very important decisions. A one-size-fits-all monetary policy in an environment characterized by rising price pressures and the persistence of some weakness of the banking sector will be extremely challenging.
- In the eurozone, GDP growth should slow only moderately this year, to 1.4% vs. 1.7% in 2010. Despite recent debt jitters, we see balanced risks to our forecasts. Overall financial market conditions remain supportive for economic growth, and improving domestic demand prospects make us increasingly comfortable about the sustainability of the recovery at the area-wide level. In particular, we continue to see a slow but steady pace of recovery in investment and consumption fundamentals, which reduces the downside risks related to fiscal tightening.
- The current level of sovereign spreads might threaten Portugal's solvency, particularly because the government needs to finance large bond redemptions in early 2011. Hence, Portugal may have no choice but to tap the EU/IMF funds soon. However, we don't see contagion spreading to Spain.
- We expect the German economy to grow by 2.5% this year after a plus of 3.6% in 2010. There is increasing evidence that Germany is now taking the first steps towards rebalancing its economy, as the positive impulses from exports are carrying over into domestic demand. Although still below pre-crisis levels, investment in machinery and equipment has picked up substantially. This, in turn, is further good news for the labor market and consumer expenditures of private households. Not surprisingly, the call for higher wages in 2011 has already become louder both by labor unions and some politicians in recent weeks.
- The inflation picture in the eurozone remains well under control, but the prevailing direction of forecast changes is now pointing up, and so does the balance of risks. For this year, we expect CPI at 2.1% with upside risks. In the first part of the forecast horizon, upside risks are mostly related to energy, while the potential for surprises on core CPI increases as 2011 progresses. Risks to our food inflation forecasts are broadly balanced, but only because we already envisage a significant acceleration during the winter.
- Despite acute tensions in periphery countries, the eurozone GDP/CPI outlook suggests that the current refi rate level has become slightly more accommodative than three months ago. The monetary analysis points in the same direction. Still, recent events show that it will take longer than previously anticipated to see the banking sector of distressed countries reducing the reliance on ECB funds. The first increase of the refi rate at end-2011 should therefore come with unlimited liquidity still in place. In the meantime, ECB's government bond purchases will probably be the main line of defense against contagion fears.
- Fixed Income: Returning risk aversion should limit a further rise in Bund and UST yields in the first half of 2011. After June, once the Fed completes its Quantitative Easing 2 and the ECB resumes its exit strategy, yields should rise more pronouncedly. The US fiscal outlook and inflation concerns should further weigh on US Treasuries. The US, Bund and UK curve should remain steep for most of 2011 and flatten only later in the year if, as we anticipate, the ECB and BoE will raise interest rates.
- Currencies: Local risk factors will continue to dominate the currency markets. EUR-USD may still suffer from EU periphery tensions in the first quarter this year, but diminishing debt woes in the second half of 2011 should pave the way for a sustained recovery.