Modest slowdown masks large divergences

Prospects for Europe have deteriorated somewhat as slowing global demand has begun to affect exports and a sharp rise in bond yields has darkened the outlook for Italy. Some of the major players should continue to perform very well. The German labour market is in particularly good health and there is cause to think that recent falls in industrial output will prove temporary. Meanwhile, French reforms seem to be bearing fruit. This positive outlook, combined with evidence of a long-awaited pick-up in euro-zone wage growth, supports our view that the ECB will ultimately raise interest rates faster than most expect. But a one-size policy will not fit all and higher borrowing costs will exacerbate divergences within the region. Italy, Spain and Portugal will be most affected, with the former at risk of a crisis. Outside the euro-zone, we suspect that the lifting of Brexit-related uncertainty will cause a rebound in the UK economy and allow the Bank of England to raise interest rates further. But the Swiss National Bank will be forced to keep monetary policy extraordinarily loose as inflation remains weak and fears about Italy threaten to boost the safe-haven franc.