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Economic Outlook

A European Economy Breathing with Both Lungs

Jason Thomas
Jason M. Thomas
Director of Research

The late start to Europe’s recovery provides a much longer runway for future growth.

The European Central Bank’s (ECB) decision to taper its monthly asset purchases from €60 billion to €30 billion is the latest sign that the euro zone economy has awakened from its post-crisis torpor. After growing at a 1% annual rate for nearly a decade, the euro zone has sustained better than 2% annualized growth for five consecutive quarters. Recent data point to continued momentum in economic activity, with growth likely to remain at or above current rates for the foreseeable future.

Figure 1

2009-2014 Euro Zone Growth Depended Entirely on External Demand1

Figure 1

The strength of euro zone economy may come as a surprise to observers conditioned to believe in Europe’s perpetual sluggishness. Yet, a closer look at the data always hinted at this possibility. The stability of the top-line GDP growth rate disguised a marked shift in how that growth came about. Between 2009 and 2014, exports boomed while domestic spending stagnated (Figure 1). The situation reversed at the end of 2014, when exports dipped and domestic spending came to account for the bulk of euro zone growth (Figure 2). Today, Europe breathes with both lungs. For the first time in a decade, domestic and external demand are growing in unison.

The “European debt” crisis that began with Greece’s near default in May 2010 sapped the confidence of consumers and businesses. Households postponed big-ticket purchases, while business investment barely kept pace with depreciation. A combination of fiscal adjustment in debtor member states, new financial rescue facilities like the European Stability Mechanism (ESM), and European Central Bank (ECB) asset purchases effectively took the risk of euro zone disintegration off the table. The concomitant rebound in consumer and business confidence unleashed pent-up demand for autos, travel, and luxury goods. Real domestic spending grew at an annual rate of nearly 3% between 2014 and 2016.

Unfortunately, the resolution of the euro crisis came at the same time that external demand faded. The collapse in energy and industrial commodity prices, and slowdown in Chinese property development and manufacturing, led to sharp deceleration in many Emerging Markets (EM) economies. Orders for European capital equipment used in mining and quarrying plummeted, while the decline in household incomes depressed demand for other European goods and services. This EM slowdown was much more consequential for Europe than the U.S. because of Europe’s large market share edge in EM economies. European businesses export twice as much to EM as their U.S. counterparts, as entrepreneurs have focused on Asia, Africa, and the Middle East instead of domestic markets for growth (Figure 3). 

Figure 2

2015-2016 Growth Sustained by Domestic Recovery as Exports Plunge2

Figure 2

Figure 3

Relative Market Share in EM Economies3

Figure 3

Today, retail sales continue to grow at an annual rate of roughly 2%, in real terms, while trade volumes have rebounded sharply. European exports to EM economies increased by an average of 7% in the first eight months of 2017 thanks to the recovery in China and broader EM, while export-sensitive German factory orders continue to grow at an 8% annualized rate entering Q4-2017. Taken together, steady domestic spending and a stronger external environment have combined to push overall euro zone GDP growth to a 2.5% annualized trend rate (Figure 4).

Figure 4

European Growth of 2.5%4

Figure 4

The ECB will Withdraw Stimulus at a Glacial Pace

The European economy no longer requires emergency liquidity support on the scale of the ECB’s current asset purchase program, but monetary policy is likely to remain extremely accommodative. With core inflation running at 1.1% and no visible signs of price pressure, the ECB has no reason to raise rates. Futures markets expect three-month Euribor to remain in negative territory for the next two years (Figure 5). The ECB will likely follow the lead of the Fed, which began to taper its asset purchases at the end of 2013, but waited to raise policy rates until December 2015 when the expansion was on much firmer footing.

Figure 5

Euribor Expected to Remain Negative Through 20195 

Figure 5

Four Years Behind the U.S.

It is common to think of Europe as typically “two years behind” the U.S. in economic cycles and there is strong empirical support for this rule of thumb.6 However, in the current cycle the euro zone looks to be roughly four years behind the U.S. The exaggerated lag is the product of two factors: (1) the Fed deployed unconventional tools at a much faster pace than the ECB, which actually raised interest rates in 2011; and (2) the Greek debt crisis revealed institutional weaknesses in euro zone governance that diverted attention from a more robust countercyclical policy response.

The late start to Europe’s recovery provides a much longer runway for future growth. Since 2009, the U.S. economy has replicated 80% of the real growth it achieved in the prior cycle (a 14.4% peak-to-peak increase in real GDP so far this cycle relative to a 17.9% increase between 2001 and 2008). The euro zone, by contrast, has only retraced 35% of the prior cycle’s growth (Figure 6). If the euro zone matches the cumulative growth achieved in the prior cycle—as the U.S. economy looks poised to do—Europe may be just one-third of the way into its current expansion.

Figure 6

Real Growth Since 2007 as a Share of Prior Expansion7 
Figure 6

Cyclical indicators of economic “slack” reinforce the notion that Europe is in the early days of the current expansion. Headline unemployment has declined steadily over the past two years to 8.9%, but part-time employment accounts for much of the improvement. When stripping out part-time workers, unemployment in the euro area remains near 18%.8 People unable to secure a full-time job choose instead to take part-time work, accept a temporary contract, or become self-employed.9 These types of alternative arrangements exert much less upward pressure on wages than full-time jobs. Average compensation rates have increased by just 1.3% per year since 2014 with few signs of near-term wage pressure (Figure 7).

Figure 7

Annual Growth in Compensation per Employee (Euro Area)10 

Figure 7

With wage and other cost pressures largely absent, most of the recent economic improvement has flowed through to stronger corporate earnings. Over the last year, operating margins have risen by 100 basis points and still have significant room to expand as sales continue to grow faster than operating expenses (Figure 8). Europe’s less flexible labor markets naturally contribute to greater cyclicality in mar-gins, as payrolls adjust to sales at a much slower rate than in the U.S. At current trajectories, margins could expand for three years before returning to peaks of the prior cycle.

Figure 8

Operating Margins Among European Nonfinancial Businesses11 


Figure 8

Cyclically sensitive investment outlays also suggest that the European economy remains much closer to the bottom than the top.12 As a share of national income, investment in euro zone property, plant, equipment, intellectual property, and infrastructure remains 13% below its 2007 peak.13 Even more striking has been the decline in construction spending and broader (public and private) real estate development, which remain 25% below pre-recession highs (Figure 9). If the “business cycle” is really a fixed investment cycle—as widely conjectured by macroeconomists for generations —the European economy looks more likely to accelerate than stall.

Figure 9

Real Construction Activity Down 25% Relative to 200714

Figure 9

Euro Appreciation and European Competitiveness

Faster growth and improved investment opportunities have naturally contributed to a stronger currency. Since March 2017, the euro has risen by 10% against the U.S. dollar and by 7.5% on a trade-weighted basis.15 Eurostat Most of this appreciation reflects a reversal in fund flows. Between 2013 and 2016, net capital outflows from the euro zone to the rest of the world averaged $400 billion per year, as domestic residents channeled savings abroad in search of higher returns (Figure 10). As domestic investment opportunities improve and ECB policy exerts less downward pressure on bond yields, more savings stay home, domestic asset prices rise, and the euro naturally appreciates. These trends should remain in place as the expansion continues.

A stronger euro could eventually depress exports and corporate profits, but Europe looks quite far from this point. A decade of moribund growth and disinflation have reduced the cost of producing goods and services in Europe relative to the rest of the world. At current exchange rates, real production costs in Europe are 18% lower than in the U.S., on average, when measured relative to a 2006 baseline (Figure 11). On a broad, trade-weighted basis, relative production costs in the euro zone have declined by 15% since the end of the financial crisis.16 The euro could appreciate materially from current levels without eroding exporters’ profits or diminishing the relative attractiveness of operating in Europe.

Figure 10

Net Capital Outflows from Euro Area.17 

Figure 10

Figure 11

Real Production Costs Relative to U.S. (2006=100)18 
Figure 11

Europe’s external competitiveness stems not only from cost advantages but also from product quality and complexity. If a product is easy to make, it is generally not made in Europe. Europe exports high value-added, knowledge-intensive products such as precision equipment, medical devices, and high-end apparel that are difficult to replicate elsewhere.19 European brands also dominate markets for luxury goods, accounting for 90% of apparel and accessories that EM consumers judge to be worth a price premium.20


The European economy finally breathes with both lungs; both domestic and external demand are growing in unison for the first time in a decade. The ECB has begun to scale back emergency liquidity support in response to stronger growth, but interest rates will remain low. Cyclical indicators suggest that Europe remains at the early stages of expansion. The euro should continue to appreciate, as higher expected returns and bond yields keep more savings home, but a decade of disinflation diminishes the threat a rising exchange rate poses to competitiveness.


About the Author

Jason M. Thomas is a Managing Director and the Director of Research at The Carlyle Group, focusing on economic and statistical analysis of the Carlyle portfolio, asset prices, and broader trends in the global economy. He is based in Washington, D.C.

Mr. Thomas serves as the economic adviser to the firm’s corporate private equity and real estate investment committees. His research helps to identify new investment opportunities, advance strategic initiatives and corporate development, and support Carlyle investors.

Previous to joining Carlyle, Mr. Thomas was Vice President, Research at the Private Equity Council. Prior to that, he served on the White House staff as Special Assistant to the President and Director for Policy Development at the National Economic Council. In this capacity, he served as the primary adviser to the President for public finance.

Mr. Thomas received a B.A. from Claremont McKenna College and an M.S. and Ph.D. in finance from George Washington University where he studied as a Bank of America Foundation, Leo and Lillian Goodwin Foundation, and School of Business Fellow.

He has earned the Chartered Financial Analyst (CFA) designation and is a financial risk manager (FRM) certified by the Global Association of Risk Professionals.

Contact Information
Jason Thomas
Director of Research
(202) 729-5420

  • 1. Carlyle Analysis; Bloomberg, October 2017.
  • 2. Carlyle Analysis of Portfolio Company Data; Bloomberg, October 2017
  • 3. Carlyle; IMF Direction of Trade Statistics Database, October 2017
  • 4. Carlyle Analysis of Portfolio Company Data; Bloomberg, October 2017
  • 5. Carlyle; CME, October 25, 2017.
  • 6. In past cycles, the recovery in Europe lags that of the U.S. by about two years, on average, while the U.S. tends to fall into recession one to two years before growth begins to slow in Europe. See: “Patterns of Euro Area and US Macroeconomic Cycles – What Has Been Different This Time?” ECB Bulletin, May 2011.
  • 7. Carlyle; EuroStat; Bureau of Economic Analysis, November 2017.
  • 8. Carlyle analysis; “Assessing Labor Market Slack,” ECB, May 2017.
  • 9. Divergence Between Unemployment and Wages in The Euro Area, Thomson Reuters, July 2017.
  • 10. ECB, November 2017.
  • 11. Carlyle Analysis of S&P Capital IQ Database.
  • 12. C.f. “Fixed Investment in the American Business Cycle, 1919-83,”
  • 13. IMF, 2017 WEO Database.
  • 14. Eurostat; ECB; Carlyle Analysis, October 2017.
  • 15. Bank for International Settlements, Exchange Rates, November 1, 2017.
  • 16. Bank for International Settlements, Real Exchange Rate Index: Broad, November 2017.
  • 17. Carlyle, IMF, 2017 WEO Database
  • 18. Carlyle, IMF, 2017 WEO Database
  • 19. Economic Complexity Index, Harvard-Atlas, 2016 Survey.
  • 20. Credit Suisse Emerging Consumer Survey 2017.
Economic and market views and forecasts reflect our judgment as of the date of this presentation and are subject to change without notice. In particular, forecasts are estimated, based on assumptions, and may change materially as economic and market conditions change. The Carlyle Group has no obligation to provide updates or changes to these forecasts.

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