The eurozone outlook hinges on labor market developments

The eurozone economy grew by 0.3% QOQ in the second quarter of the year, in line with Q1 but slightly stronger than expected. Ireland (1.2% QOQ) and Spain (0.8% QOQ) clearly outperformed their peers, while Germany was the main laggard (-0.1% QOQ). Ireland’s figure should be taken with a grain of salt, however, as the statistics are distorted by tax-induced international financial flows. Excluding Ireland, eurozone GDP growth was roughly in line with our inhouse forecast of 0.2% q/q. Details are still lacking, but based on the national data available, manufacturing and construction activity contracted, whereas activity in the services sector grew.

Going forward, different survey indicators paint a slightly different picture, but overall they suggest that economic growth is likely to remain moderate in the near future. On the one hand, PMI indicators show that private sector activity weakened in recent months (see figure 2). On the other hand, economic sentiment has broadly flatlined over the past months, according to survey indicators of the European Commission. We project quarterly economic growth of around 0.3% QOQ in the coming year(s), roughly in line with potential GDP growth, but with downward risks to the short term outlook. Consumption growth will be the main driver. We expect household spending growth to pick up after a very weak 2023, on the back of improved purchasing power.

Employment growth will be weak in the coming quarters. This doesn’t mean that we expect a wave of job cuts, but we expect the demand for labor to moderate and the recent gap between GDP growth and employment to narrow.

Strong employment figures have sustained household consumption over the past years, supporting the economic recovery in the aftermath of the pandemic and helping households cope with the subsequent cost of living crisis. Indeed, employment fell rather mildly compared to the major drop in economic activity during the pandemic and has grown strongly since. Never before have so many people been employed in the eurozone as today, with employment rates at historical highs and the unemployment rate at a record low (see figure 3).

All in all, the labor market has performed much stronger in the past years than anticipated, and arguably stronger than “justified” by economic activity. For example, employment is currently 2% higher than Okun’s law (which definitely has its flaws) estimates based on GDP growth in the past quarters. Surveys also suggest that the share of businesses holding on to a larger workforce than business activity requires was higher in the past couple of years than before the Covid-19 pandemic (see figure 4).

Labor hoarding is not an unnatural phenomenon. It’s often more attractive to retain workers when economic activity slows than to let employees go and hope to find similar expertise when activity picks up. Based on this logic, the current environment gives companies plenty of reasons to hoard labor, as it is hard to find qualified workers in most sectors. Additionally, especially in industry and construction, profit margins rose significantly in the aftermath of the pandemic, giving companies the means to retain their employees and hoard labor.

Going forward, this may change. Profit margins in the manufacturing sector are dropping quickly and margins in the services sector are already slightly below their pre-pandemic average. This may force companies to scale back hoarding, or at least discourage them from increasing it, especially given that the outlook is bleak. For one, because unit labor costs are rising, as wage growth has overtaken productivity growth. Furthermore, due to the weak demand environment, it remains difficult for companies to fully pass on increasing input costs to final consumers, especially in the manufacturing sector.

Additionally, the labor market is also loosening somewhat. Though unemployment rates remain low, the vacancy rate has fallen significantly since peaking at the start of 2022. It does remain well above pre-pandemic levels, but still indicates that companies are becoming more hesitant. The strong recovery after the pandemic prompted some companies to post vacancies just in case they needed the extra capacity. Now that the economic outlook isn’t as rosy, companies are withdrawing those vacancies and we’ve already seen employment growth slowing.

To the discomfort of the European Central Bank, wage growth has picked up considerably over the past two years. Spurred by high inflation and tight labor markets, wage growth reached almost 5% in the first quarter of the year. We anticipate that wage growth will slow somewhat over the coming quarters, but remain strong for several reasons.

First, as explained in the previous section, we expect the labor market to remain tight. Second, we expect (core) inflation to remain elevated for the next few years. The sellers’ market for labor, demand for catch-up wage growth, and aggregate healthy profit margins all provide fertile ground for future pay increases. The story is slightly different for the manufacturing and services sectors. Companies in industry and construction could still dip into their buffers to pay for higher wages, even if demand is too weak to fully translate higher input prices to higher output prices. Services providers arguably still have more pricing power at the moment, which also fits the narrative of sticky services inflation.

Nevertheless, now that economic growth is weak, something has to give. Companies simply can’t continue to increase wages if productivity and profitability don’t follow suit. We will either see lower wage growth, lower employment growth, or lower profit margins. Given the state of the labor market and sentiment in Europe, we think it’s most likely that employment growth will be slow, that profit margins will fall a bit further, and that wage growth will slow somewhat but remain strong and higher than inflation (see figure 7).

We can already see some early signs of this in Germany. The recent purchasing managers’ indices showed that unemployment is ticking up now that demand is falling and profit margins are under pressure. But this dynamic is unique to Germany. For other eurozone member states, we still expect unemployment to stay roughly the same in the near future.

In the long run, we do expect things to balance out. We expect real wages to recover to pre-pandemic levels sometime in 2025 and, with inflation dropping in the next few years, it’s likely that nominal wage growth will follow suit.

We expect employment to remain roughly equal to where it is now for the coming quarters. This implies that any growth in consumption will have to come from wage increases and/or higher disposable incomes for people outside the labor force, such as retirees. Based on our expectations for wage and population growth, we expect consumption growth to come in just above 1% in the coming years.

Despite dismal reports about weak foreign demand for European goods and services, net trade has been a driver of GDP growth in the past quarters. But this wasn’t due to strong exports. It was actually due to weak imports (see figure 9). This is not exactly a show of strength.

Weak economic activity in China is one of the biggest explanations for sluggish foreign demand. The world’s second biggest economy is grappling with a real estate crisis and weak consumer demand. We don’t expect this to change anytime soon. China’s recent Third Plenum underwhelmed investors as it presented few concrete policies to reinvigorate its debt-laden economy. China’s consumers are still held back by worries over the value of their real estate. Moreover, despite the fact that Chinese consumers are reluctant to spend, China’s factories are advancing at full speed. This had led to a glut of overproduction and even deflation at some point.

We also expect weaker growth in demand from the US in the second half of this year, as the economy is losing steam. The US presidential elections could also throw a spanner in the works. Based on the current polls, we assume there will be a second Trump presidency (although we fully acknowledge that things can shift in four months). The former president has been rather vocal regarding his intentions for his second term. He promises higher tariffs on imports from China and Europe (see this report), which would likely lead to a weaker trade balance with the United States.

The outlook for investment is mixed. For the year 2024, we still expect private investment to decline as a result of the 1.4% QOQ contraction in the first quarter. We do have to take those figures with a grain of salt, however, as Ireland’s statistics significantly cloud the picture.

On a more structural level, we expect business investment to remain lacklustre in the eurozone for the coming quarters. The capacity utilization rate in Europe has only fallen further since we last wrote about our outlook for investment. This holds true for both the manufacturing and the services sectors. Those low capacity utilization rates leave little incentive for companies to invest in extra capacity. Luckily, there are still compelling reasons to invest. European manufacturers increasingly invest in cost-saving techniques or to replace written-off equipment. This trend has accelerated in the past years, as energy and personnel costs rose quickly.

Moreover, the latest Bank Lending Survey indicated that the biggest shock to lending standards appears to have faded. Banks did still report a small net tightening of credit standards for loans to enterprises, and enterprise loan demand remains somewhat dampened by higher rates.

Meanwhile, the consumer side is more optimistic. The lending standards for mortgages eased moderately, while consumer confidence, improving housing market sentiment, and spending on durables supported household loan demand. The credit impulse - i.e., the contribution of credit to growth - is broadly neutral again.