Europe’s economy looks modestly stronger, but the continuing wave of populist politics threatens to slow things down.

If you only looked at the headlines in early February, you’d think the eurozone was about to break up. Greece has returned to the stage, locked in difficult negotiations with its creditors. Marine Le Pen is polling ahead of everyone else for the first round of French presidential elections. Advisors to President Trump have labeled euro weakness as a German plot to cheapen the currency for German exporters. But are things in Europe really so bad?

While we think a political shock in Europe would generate significant market instability, and while we agree the tail risk of a eurozone breakup is real, we also think the risk of a political earthquake is small. The real risk is that populist opposition movements, while not powerful enough to take control, act as a long-term brake on the reforms needed to energize growth in key countries and make European institutions more robust.

Economic improvements have spread

Our view is that things in Europe look a little bit better now, despite the headlines. There is not much that is new in the Greek drama. Germany is a little bit stronger, and the French recovery is further advanced than we had thought. In France, the terrorist attacks of the past 13 months took a toll on the economy of perhaps 0.1% of GDP (via lower exports of tourism services), but this is now passing out of the data. Measures undertaken early in 2016 to lower the corporate tax burden appear to have been successful in boosting profitability, and investment is now rising a little as a result. What’s more, fiscal tightening is coming to an end.

Taken together, these factors should allow France’s 2017 GDP growth to be about 0.2 points higher than in 2016, with perhaps some upside risk if Le Pen loses the presidential election, as we expect. This upward revision in France and mild positive surprises in Germany, Italy, and Spain could add about 0.1% to 0.2% to the European growth rate. This is not enough to change the outlook decisively, but it does mean the output gap is a bit smaller than we had thought. Our European Nowcast illustrates these broad economic improvements.

While we think a political shock in Europe would generate significant market instability, we also think the risk of a political earthquake is small.

The conversation around inflation has also changed. Actual inflation has been moving in line with our forecasts, which for a while now have shown two peaks of headline inflation above 2% in 2017, before it drops to 1.5% at the end of the forecast horizon. The European Central Bank (ECB), acknowledging the upward move in headline inflation, has been trying to shift the terms of the discussion away from what it sees (correctly, in our view) to be a temporary rise. Nevertheless, the bank is constrained by its headline inflation target and its history as a bank that attaches little value to core inflation.

The ECB calculates a large number of measures of what it calls “underlying” inflation, some of which simply exclude certain components (as in the traditional U.S. concept of “core”). Others take a more statistical approach to the problem. Yet all of them show annual rates of inflation between 0.9% and 1.1%, and all of them are moving sideways. Within the economics department at the ECB in Frankfurt, and among Mario Draghi and his closest allies on the Governing Council, there is a strongly held view that inflation pressures remain very weak and that monetary policy needs to remain accommodative.

On the other hand, the discussion among many market participants and the more hawkish members of the ECB board is increasingly resisting this view. In Germany, for example, headline inflation is at the ECB’s target, and there is rising confidence in the resilience of the cyclical upturn.

Sensitivities to political risk

Beyond these macro data, politics have been in focus recently because of the approach of major elections and because, after Trump and Brexit, markets have become more sensitive to political risk.

At the margin, we are slightly more optimistic on this front now, reflecting developments in France, Germany, and Italy. Briefly, in France the election seems highly likely to put a reformer in the Élysée, and the popular mood is edging to greater support for a range of economic reforms. A victory by Le Pen seems highly unlikely. In Germany, the election campaign has not officially begun, but it will be a closer contest than what seemed likely a short while ago, and this raises the chance of a modest change in German policy. In Italy, the risk from the Five Star Movement remains contained.

On polls and Le Pen

By way of closing, we acknowledge that Trump and Brexit votes have made people skeptical of opinion polls. But in both of those cases, the issue/candidate was new, and the election margins suggested by the opinion polls were small and within polling margins of error. Moreover, Trump’s performance in the popular vote was exactly in line with opinion polls. For Le Pen, there are actual votes in the recent past to consider, and the margin by which she trails in opinion polls is far outside the margin of error.

The Trump and Brexit votes have made people skeptical of opinion polls, but for Marine Le Pen there are actual votes in the recent past to consider.

Le Pen is likely to advance to the second round of the presidential contest in France. But can Le Pen win a second-round contest? It’s the overwhelming opinion of French experts that she cannot. They believe her support is capped at just below 30%. For Le Pen to win a second-round election against Francois Fillon — or whomever replaces him as the candidate of the conservatives if his current scandal obliterates his candidacy — she would need to appeal to left-wing voters, but all the detailed polling data we have suggest this is highly unlikely. The demographics (age, income, wealth, education, geographical location, occupation, and religion) of the remaining leftist voters are highly unfavorable for Le Pen.

It’s worth adding, however, that many analysts who think her vote will be capped below 30% this year also think that the work Marine Le Pen has done, softening the image of the Front National (FN) and distancing herself from her father, may well make her a plausible enough candidate to be elected in 2022 as younger voters, with less experience of the FN’s history, enter the electorate.

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