Key Takeaways

- We expect the eurozone economy to slow further in 2020 to 1.1% growth, down slightly from 1.2% in 2019, on the back of weaker external demand.
- German Bund yields are set to remain in negative territory until 2022 given the secular stagnation in the eurozone and the ECB's monetary policy, which exacerbates the shortage of what investors consider safe assets.
- Parallel reduction in private- and public-sector debt since the eurozone crisis has been a key reason for weaker potential growth, but now that government yields are significantly below GDP growth, fiscal policy should come to the rescue.

S&P Global Ratings believes economic weakness in the eurozone is now set to extend into 2020 considering that we see no rebound in external demand. Global trade growth is hovering around zero, trade tensions persist, and Chinese GDP growth is likely to slow to below an annual 6%. The main pillar of growth in the eurozone remains consumption, thanks to tight labor markets and dynamic wage growth. Yet, the economy is slowly starting to feel the effects of the trade-related manufacturing slowdown. Capacity pressures and employment expectations are all easing, pointing at a deceleration in investment.

The divergence in the services and industry sector has worked as a sudden and unexpected asymmetric shock on the eurozone economy. Germany remains the most affected by the collapse of world trade due to its overreliance on exports for growth. Italy is second in line, but a reduction in political uncertainty and sovereign risk premiums should lend some support to business confidence and boost domestic demand in 2020. France and Spain stand out as resilient so far because the trade slowdown affects them mostly through second-round effects-that is, the slowdown in growth of their large eurozone trade partners. Unlike Italy and Germany, they have also kept growth in unit labor costs in check over the past few years. In addition, French consumers are benefiting from supportive fiscal measures.

Amid the economic weakness, the European Central Bank has once more pulled all of its easing levers to support growth and inflation. It has pushed rates further below zero and ensured that government yields will continue to trade in negative territory for a while with the resumption of net asset purchases from November. Looking at our inflation forecasts and the ECB's forward guidance, we don't expect any rate hikes before 2022.

Is the eurozone entering secular stagnation?

The eurozone has reached a state that looks a lot like secular stagnation: low growth and low inflation with plenty of interest rates in negative territory. With a current account surplus of close to 2.9% of GDP in 2018, the eurozone is also saving more than it invests in spite of negative rates.

As such, eurozone investment has barely recovered from its pre-financial crisis peak in 2019, negative real rates have yet to spur growth, and underlying inflation has been stuck at 1% for a while now.

Granted, the current slowdown has come from an external shock, but there are also structural factors at play behind low growth and low rates.

- Potential growth in the eurozone has decreased from 2% between 2000 and 2008 to 1.3% since 2009. This is not just linked to a slow recovery in investment, but also meager improvements in total factor productivity and a worsening demographic profile. Lower growth points to lower returns on investments, contributing to lower rates.

- Excess savings, combined with safe asset scarcity, is also pushing down rates. With a rising dependency ratio (the number of retirees compared to the working age population), we can even expect savings to rise further in the eurozone, especially in aging countries like Germany.

Meanwhile, the supply of government bonds is set to remain constrained by two factors for the near future: the ECB's asset purchases and holdings as well as low sovereign bond issuance, as eurozone governments are still downsizing debt.

- The eurozone remains relatively highly leveraged, which acts as a constraint to both growth and rates. Since the financial crisis, firms have become wary of taking on more debt. In almost all eurozone countries except France, they have become net savers. Although less credit-fueled growth likely means the sources of growth are more sustainable, it also means there is less investment in the economy and thus lower potential growth.

All of these factors have pushed down the so-called neutral rate (the theoretical level that supports the economy at full employment or maximum output while keeping inflation constant) of the eurozone economy. As a result of this and the ECB's new asset purchases from November, we now expect German Bund yields to remain negative until 2022 (see our forecasts at the end of this report).

Secular stagnation does not have to be a trap: fiscal policy and structural reforms can help

Given all of the factors mentioned above, it would seem that secular stagnation has reached Europe. But some of it can be reversed. The parallel deleveraging of the private and public sector has been a key reason for weak investment and therefore weak productivity growth since the eurozone crisis. And, monetary policy has also been the only game in town. Yet, the effectiveness of monetary policy is decreasing.

While debt reduction was and still is necessary for some eurozone countries, others have regained enough fiscal space to use it to boost growth. Perhaps more importantly, the times are very different than in 2010. Interest rates on government bonds are significantly lower than nominal growth and even negative on most parts of the yield curve for most countries.

Therefore, it makes sense for governments to borrow more to finance growth-enhancing projects. One option already heard in the Netherlands or Germany is to use fiscal space to finance the transition to greener growth. Besides, governments have other tools than fiscal policy to boost growth. Structural reforms can have a positive impact on productivity by facilitating a more efficient reallocation of resources.