Europe's biggest economies, including Germany, face significant headwinds, and a no-deal Brexit may tip the scales on growth.

The eurozone's economy is showing the effects of both local and global developments. The region is flirting with an economic contraction. Brexit may also be playing a role here. The European Central Bank (ECB) said it expects its key interest rates "to remain at their present levels" at least through the end of 2019. In March, the central bank announced a new program to stimulate bank lending in the eurozone: The targeted longer-term refinancing operations (TLTRO-III) will provide loans to banks starting in September 2019 and ending in March 2021.

Worries about Germany's economy

There's no question that the German economy, the eurozone's largest, has hit a difficult patch. Germany has felt the full force of the slowdown in China, a major trading partner and export destination. Trade between the two nations has softened amid uncertainty caused by the U.S. tariff dispute with China. Germany's exports to Turkey have also slumped as the Turkish economy cools. Manufacturing in Germany looks very weak. In February, industrial production — excluding energy and construction — and manufacturing orders declined. Both export and domestic orders slumped.

The EU's limits on car pollution also posed a threat to Germany and the region's auto industry. The auto sector has failed to recover from the switch in emission standards in 2018, which included incentives to boost the sale of clean and zero-emission vehicles. The threat of U.S. tariffs on European autos has hurt business confidence in the region. In France, economic indicators have slipped because of political protests. And Italy's economy is contracting.

Weakness in exports

The eurozone is a slow-growing economy at the best of times, and it's also less volatile than the United States. The region's public sector is large, and automatic stabilizers are powerful; therefore, the downturns in Europe tend to be mild. Domestic demand has also held up reasonably well. In Europe, however, the weakness tends to start in the export sector, which then squeezes corporate profitability, and leads to labor market weakness. These affect household spending. Thus far, the export weakness has not been enough to completely offset the growth in domestic demand, despite Italy's self-inflicted contraction, but things are delicately poised.

Eurozone GDP remains weak

A hard or soft Brexit?

The United Kingdom's exit from the EU also poses a risk to the eurozone, especially countries that are most exposed to a breakdown in trade with Britain. A "no deal" Brexit will affect the United Kingdom and may be enough to tip the barely growing German economy into contraction. However, that is not our central case.

European leaders agreed in April to allow more time for Prime Minister Teresa May and the U.K.'s parliament to sort out the country's exit from the EU. The latest signals from London suggest a soft Brexit will be very likely. However, political tensions inside the Conservative Party are serious, and May's government has repeatedly demonstrated an inability to reach a deal. Therefore, we cannot exclude the possibility that the United Kingdom will crash out of the EU without a deal.

Inflation surprises

Brexit and slowing economies aside, the eurozone also has to contend with negative inflation surprises. Core inflation — which excludes energy and food prices — in the 19 countries sharing the euro fell to 0.8% in March from a year earlier. That is below the normal range of between 0.9% and 1.2%. The data may be concerning for the ECB because it has long predicted a pickup in core inflation, the rate that is used in the central bank's policy decisions.

The eurozone's underlying inflation is unlikely to move very much.

The eurozone's underlying inflation is unlikely to move very much. The recent downward revisions in the ECB's inflation forecasts were a reaction to the failure of core inflation to move higher in 2018. We don't believe the ECB will see anything in the March inflation report that warrants a further downward revision. Moreover, the recent uptick in oil prices and the depreciation in the euro will add just a little bit of upward pressure to headline inflation in coming months.

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The global economy is showing a few tentative signs of improvement, but risks remain.