Croatia: Prolonged Middle East conflict reshuffles the outlook

GDP growth revealed a solid, but softer-than-anticipated entry into 2026, with 1Q26 posting 2.2% y/y (vs. 3.9% y/y in 4Q25). Domestic demand remained supportive, with private consumption expanding at a healthy 2.6% y/y, while public consumption (0.7% y/y, the weakest print in almost four years) and investments (2.5% y/y) shifted into a lower gear; net exports weighed on the headline as goods exports declined. Looking ahead, private consumption faces mounting headwinds from rising inflation and anticipated real wage growth moderation. Investment momentum, while backed by EU fund flows, should confirm the moderation base effect and global uncertainties. The external outlook remains blurry, with the focus turning to tourism, where some ‘security’ premium should offset demand headwinds. Given the prolonged Middle East conflict, we have trimmed the 2026 GDP outlook to 2.1%.

Inflation has firmly taken over the spotlight, with the prolonged Middle East conflict pushing the price trajectory considerably above the pre-conflict baseline. Headline inflation hit 5.8% y/y in April before easing to 5.2% y/y in May, with the surge-shaped by energy prices (17.7% y/y in April) and persistent (demand-driven) services pressures holding around 8% y/y, while food and industrial goods have thus far remained relatively immune (yet upside risks remain). Assuming limited further escalation and gradual normalization towards year-end, we see average 2026 inflation in the 5% neighborhood, with the balance of risks clearly tilted to the upside. On the positive side, there is the government's recently presented 'anti-inflation' program, demonstrating a commitment to supporting administratively set energy prices. On the fiscal side, the April EDP notification put the 2025 budget gap at 3.0% of GDP, marginally above the official 2.9% target. The fiscal course remains largely unchanged under new Finance Minister Ćorić, though the 'anti-inflation' program brings some focus to consolidation (expenditure trimming worth 1.4% of GDP, a public wage freeze until 1Q27, taxation of excessive profit margins), yet with pending details and immplementations risks. After S&P's upgrade to 'A', Moody's (as expected) remained more conservative, affirming 'A3' (stable).

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