Europe needs comprehensive industrial policy to withstand populist forces
European Parliament elections will be determined by inflation, the Russia-Ukraine war and the growing influence of extremes, explains Geoffrey Yu, senior strategist at BNY Mellon.
Despite all the economic and geopolitical uncertainties facing Europe and the world, it is often bread-and-butter issues such as jobs and inflation that decide the outcome of elections. This year’s European elections are no different.
Recent challenges such as high inflation, energy costs and supply shortages have been alleviated and the European Central Bank is in a position to loosen monetary policy, further providing relief to households. However, there are severe structural headwinds such as demographics pressures, further deglobalisation and the future of Europe’s manufacturing sector all threatening trend growth.
Based on current trends, the risk is that electoral decisions in Europe – not least the European Parliament elections – deliver results that would hardly be conducive to resolving these problems.
Expect looser monetary policy
Monetary policy relief is perhaps the one positive certainty for the euro area economy in 2024. We expect ECB rate cuts to match or even surpass the Federal Reserve’s plans, due to Europe’s growth concerns. Meanwhile, the euro is overvalued and the ECB may see it at as a disinflation risk. We believe the euro-dollar exchange rate will touch parity this year before stabilising, while the market sees the pair staying above 1.10 by year-end.
For interest rates, market pricing points to the ECB cutting in Q1, though we suspect that the governing council may choose to wait until April or just after the Fed moves to give itself some room. However, structural headwinds for the euro area, from very weak fiscal impulse to competitiveness losses in the auto sector, most likely mean severe growth risks and so require a stronger response.
We are already seeing investors react. Our custodial flows indicate that cross-border flows into industrials, in particular autos and components, deteriorated materially through the second half of 2023. The rise of China’s battery electric vehicle exporters threatens to disrupt global auto markets that deliver much of Europe’s industrial value-add. A growth-damaging trade dispute between the European Union and China might loom. High-frequency data suggests significant labour market deceleration in euro area services, adding to problems already in manufacturing.
The risk is that neither sector can recover in the short and medium term. Fiscal impulse does not look likely given the direction of travel for German and EU politics. The combined growth and disinflation risks could trigger an ECB policy response sharply divergent to the Fed. The ECB may even choose to lean against the euro as an alternative measure to loosen financial conditions.
Geopolitical tensions persist
Meanwhile, market views around the war in Ukraine appear to have faded to it being a constant – a drag on Europe and emerging markets. We think the chance of a cessation of hostilities is under-priced. Observers of geopolitics have cited three main ways the war might resolve: Russia’s election in March causes President Vladimir Putin to soften his stance; China, the US, Saudi Arabia, United Arab Emirates, Qatar or other nations broker a peace deal; or Russia or Ukraine wins outright. In terms of markets, we think the net result of any peace could be significant in the respect of infrastructure rebuild – and in the debt needed to pay for it. This could result in inflation risks rising again.
After EU leaders voted to start accession talks with Ukraine in mid-December, the remaining sticking point is the EU’s €50bn financial package to support Ukraine’s military. Hungary vetoed the financing package, which will again be on the agenda at the EU leader’s meeting on 1 February. The key risk is that Hungary’s veto effectively paralyses EU decision-making on Ukraine.
Rise of the far-right?
Heading into the June elections, focus will be on the larger member states, specifically Germany, France, Spain and Poland. Given the large size of their EU parliamentary delegations, a significant strengthening of the far-right ahead of the elections could have implications for the composition of the European Parliament.
Current polling still suggests a majority for the centrist parties, namely the European People’s Party (centre-right), socialists (centre-left) and Renew (centrist, liberal) – but also a significant strengthening of support for the European Conservatives and Reformists (eurosceptic right) and Identity and Democracy (far-right). The key risk to watch for is if populist parties can block decision-making. For now, the base case assumes a majority for the centrist parties.
It is difficult to predict how a supposed ‘populist’ result will impact the medium-term macro outlook for Europe, especially with much of the world moving in the same direction. The EU alone cannot change or counter this but formulating a comprehensive industrial policy akin to ‘Made in China 2025’ or the US Inflation Reduction Act will become even more urgent. How the new European Parliament rises to this challenge will determine Europe’s resilience in an increasingly de-globalised and supply-stricken world.