The unexpected strength of the eurozone recovery was the big surprise of 2017 and one of the main reasons why the UK economy outperformed gloomy pre-Brexit forecasts.  Eurozone output expanded by 2.3 per cent last year, the strongest growth for a decade and far ahead of the consensus forecast among independent economists at the start of the year of growth of just 1.3 per cent. Business and consumer confidence at the start of 2018 was the highest for 18 years, prompting economists to upgrade their expectations for growth this year to an average of 2.4 per cent, up from a forecast of just 1.5 per cent a year ago.

But are the wheels now coming off the recovery?  A string of weak data points to a disappointing first quarter.  German exports of goods were down by 3.2 per cent in February compared with January, defying consensus expectations of a 0.4 per cent rise.  German industrial production also fell by 1.5 per cent in February, compared with a forecast of a 0.3 per cent rise.  Fresh data this week suggests the slowdown is spreading: Italian industrial production fell by 0.5 per cent in February compared with the previous month, while manufacturing output fell in France for a second consecutive month.  This disappointment is reflected in equity markets: the Stoxx 600 index of leading European stocks is down 7 per cent from its January peak.

Of course, a couple of months of weak data may not signify anything much.  Most economists are inclined to think this is a temporary dip, offering explanations ranging from the cold winter across much of Europe to the strength of the euro to a bad dose of the flu that pushed up sickness rates in Germany.  Others have pointed out that recent survey data, which also has been weaker than expected, still points to healthy levels of growth: the eurozone composite PMI — a broad measure of economic activity — fell from 58.8 in January to 55.2 in March, but that is still consistent with first-quarter growth of 0.7 per cent, lower than the 0.9 per cent forecast in January but a long way short of a downturn.

Even so, there are several issues that will need to be watched closely in the coming months that have the potential to turn a slowdown into something more troubling.  The first is that even with growth slowing, some parts of the eurozone may still be at risk of overheating.  That’s because the eurozone has already been growing for several years above its long-term potential growth rate — the rate at which an economy can grow without generating inflation — which is widely estimated to be a meagre 1.5 per cent, reflecting the Continent’s demographic challenges and the inflexibility of many eurozone economies.  Already there is worrying evidence of bottlenecks in some industries and reports of skills shortages in many countries, not least in France, despite unemployment of 9.2 per cent.  The risk is that supply-side constraints hold back growth while pushing up inflation, a worrying combination.

A second concern relates to the present global trade tensions. The eurozone is particularly vulnerable to any disruption to trade: it runs a vast current account surplus equivalent to 3.6 per cent of its output, which means it is highly reliant on foreign demand to fill its factory order books. Indeed, the eurozone has been the big winner from China’s booming economy in recent years: exports to China were up 21.9 per cent in 2017, while net trade was the biggest contributor to eurozone growth last year at 1.3 per cent. Even the recent pick-up in capital expenditure, which contributed 0.5 per cent to eurozone gross domestic product growth in 2017, was in large part driven by Chinese demand. Indeed, some of the present slowdown appears to reflect a slowdown in Chinese growth and tighter Chinese credit conditions.

The third concern relates to global liquidity conditions, which have been tightening all year as the Federal Reserve has raised interest rates and started to shrink its holdings of government bonds and as the European Central Bank has slowed the pace of its own bond-buying. US ten-year Treasury bond yields have already risen from close to 2 per cent in September to 2.8 per cent today and could be driven higher by a combination of increased bond issuance needed to fund President Trump’s tax cuts and expectations of higher inflation as the extra stimulus is applied to an economy already running at full capacity. Rising interest rates against a backdrop of slowing global growth could trigger fresh worries about the vast quantities of private sector debt issued during recent years across developed markets raising the risk of another bout of market-driven economic instability, notes Ian Harnett, of Absolute Strategy Research. Markets that may be vulnerable to fresh credit risks include the US corporate bond markets, which have grown by 50 per cent in four years; the Canns (Canada, Australia, Norway, New Zealand and Sweden); and highly leveraged eurozone economies, such as France and the Netherlands.

Of course, the eurozone’s ability to withstand these risks would be enhanced if it had a compelling economic story to tell in the form of reforms designed to improve its productivity at national level or strengthen its resilience at eurozone level. In recent years, the currency bloc has been able to count on remarkably benign market conditions as investors have piled into eurozone assets, eager to play the recovery trade as the economy rebounded from its debt crisis.  But with growth possibly slowing and in the absence of meaningful reform efforts anywhere other than in France, that trade looks to have played out.  Indeed, the eurozone’s biggest challenge lying ahead may be simply to maintain investor interest.

Meanwhile, Eurozone unemployment has fallen to its lowest level in almost a decade and inflation has picked up in a further sign that the currency bloc’s economy is gathering momentum.  Joblessness dropped to 8.5 per cent in February, the lowest since December 2008.  This compares with 8.6 per cent in January and 9.5 per cent a year ago. Meanwhile, inflation in March jumped to 1.4 per cent from 1.1 per cent in February, official data showed.  Strong job creation and rising inflation is what policymakers want to see.  The European Central Bank has been pumping cheap credit into the economy to drive growth and kick-start inflation.  The efforts have paid off over the past year, with GDP growth surging above 2 per cent to a decade-long high and unemployment tumbling.  However, in France unemployment is still at 8.9 per cent, in Spain at 16.1 per cent and Italy 10.9 per cent.  In Germany and the Netherlands unemployment is low — at 3.5 per cent and 4.1 per cent, respectively.  There are 13.9 million unemployed people in the eurozone, 1.4 million down from a year ago.

Recent figures showed that German industrial output suffered its steepest monthly drop in more than two years as protectionism’s spectre loomed over the export-driven economy.  Seasonally adjusted output fell by 1.6 per cent in February after rising by a revised 0.1 per cent in January, Destatis, the statistics authority, said.  It was the biggest drop since August 2015.  Data already showed that industrial orders had risen by less than expected in February because of weak domestic demand.

Finally, as reported above, growth in the eurozone economy has “downshifted markedly” since the start of this year, according to the purchasing managers’ index, which is considered one of the best indicators of how the eurozone is performing;

Taking into account the overall uncertain picture of the eurozone economy and its future investment prospects for our clients, we took the decision last month to reduce our model portfolio exposure to European smaller companies funds by 50%, adding the proceeds to cash reserves, pending future investment.  Nevertheless, we have retained some exposure to the European sector, as markets don’t always behave in the way analysts predict and can (and often do) surprisingly outperform expectations.