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Europe is expected to return to economic growth in 2014, but a 1 percent rate is a long way from the rates common before the global financial crisis.

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Europe Expected to Return to Positive Economic Growth in 2014

  • 5/19/2014

The members of the eurozone face a number of critical decisions in 2014 if they are to put in place an effective system to prevent a rerun of the banking crisis and regain public support. Meanwhile the European Central Bank (ECB) is under pressure to provide more stimulus as a new economic threat, outright deflation, starts to rear its head.

Is Europe finally on the road to economic recovery?

The consensus view is that Europe will return to economic growth this year, but that the growth rate is unlikely to exceed 1 percent in 2014 —a long way from the higher growth rates that were common before the global financial crisis. Surveys of business expectations, including the widely followed purchasing managers’ indices, are picking up in many European countries. Consumer and business confidence ratings are also improving. However, none of these indicators yet point to anything more than meager economic growth this year.

Main areas of vulnerability

Unemployment in the eurozone has continued to rise. It now stands at more than 12 percent, nearly twice the U.S. and U.K. average. That will not start to fall until growth resumes in earnest. Bank lending remains weak by historical standards and borrowing costs for the troubled periphery nations remain too high for comfort. In its latest quarterly economic assessment the European Commission admitted that Europe’s productivity record since the mid-1990s has been poor and made worse by widespread misallocation of resources during the credit boom. On the positive side inflation has been falling, but even that poses new risks of its own.

Deflation a concern

With the average rate of inflation in the eurozone now down to 0.8 percent per annum, deflation is hazardously close to taking a grip. Due to their negative rates of growth, many countries in Europe have been unable to make any inroads into their high debt levels since the crisis. According to Bloomberg, the vast majority of eurozone members have debt-to-GDP ratios above 80 percent, well above the maximum limit mandated by the treaties which created the euro in the 1990s. The ECB doesn’t see deflation as an imminent threat. The main problem it faces is not having the same freedom to deploy stimulus measures as other central banks, including quantitative easing. Such programs appear to be ruled out by European treaties, but governments could agree to override the restrictions if a new deflation crisis seems likely.

Preventing another banking crisis

In November 2014 the ECB will formally take on a new role as the lead supervisor for the largest banks across the eurozone, taking a lead role in winding up or rescuing any that get into financial distress. All the banks will be subject to both an asset quality review and a “stress test” to estimate the resilience of balance sheets to economic and financial downturns. This new bank resolution regime is only one of a broader range of measures that are needed to create a genuine banking union across Europe. European governments currently lack public support to go any further towards this ultimate objective.

Looking forward not back

Despite these potential difficulties, investors have become much more positive about Europe since the middle of 2013. Borrowing costs of the most troubled “periphery” countries have continued to fall quite sharply, reflecting the market view that the risk of the eurozone breaking up has largely disappeared. The euro has been surprisingly strong and European shares have outperformed those of the U.K. and U.S. It is the job of financial markets to look forward, not back, and investors’ current verdict is that growth will return. This is the year when we will find out if this renewal of confidence in Europe’s future is justified or not.