Eurozone Outlook: Out of the Frying Pan…

Our Forecasts

Source: Continuum Economics, Eurostat

Risks to Our Views

Source: Continuum Economics

Eurozone: …Into the Fire!
First the good news; the EZ economy has seen a number of positive developments in recent months, most notably being the drop back in benchmark gas prices back below pre-war levels, helped by a sharp fall in gas consumption and continued diversification of supply sources, including recourse to new LNG supplies. As a result, and despite the energy shock and ensuing record high inflation, instead of slumping, the EZ economy managed a broad stagnation last quarter, with the added support coming from a further easing in supply issues. This better end to 2022 has created a positive base effect that (alongside a slightly softer inflation picture), partly explains our upgrade to the GDP projection for this year to 0.1%, a contrast to the 0.5% drop envisaged in December.

But now for the more sobering news: there are shadows amid the backdrop and outlook in spite of the more hopeful messages from recent business and even consumer surveys. For a start, the flat Q4 GDP reading actually included a sharp fall in domestic (and particularly consumer) demand, which we think will continue through H1 this year. This means that a formal recession is still on the cards, albeit likely to be much more modest and short-lived that previously thought. This domestic weakness is already causing a reversal in what has hitherto been a solid labor market, with the rise in the workforce now occurring alongside a rise in unemployment which we think will both extend into 2024 at least and continue to restrain wage pressures. In this regard, the likely huge influx of Ukrainian refugees (already over 4 mln thus potentially adding a further 3% to the workforce) is likely to be a factor boosting the EU workforce more significantly and broadly in the next 1-2 years.

Figure 1: Clearer Monetary Weakness Poses Increasing Risks to Activity

Source: ECB, Continuum Economics

Instrumental in the outlook is the impact of tighter financial conditions, ushered in by what has been the fastest rise in official interest rates on record. However, it is not just the much greater speed and size of recent hiking that we think is and will take a further toll on activity, but the fact that bank credit standards seem to be tightening as well (see below). But there are now broader signs that policy is biting in a potentially more adverse manner, given the manner in which private sector credit and money growth have stalled, if not collapsed, both posing serious downside risks for real and nominal activity (Figure 1). All of which underscores our current premise that while the shock to the EZ economy from energy may have diminished it has replaced by a monetary one in which financial conditions have tightened rapidly and broadly and now where this may be amplified by stresses from the banking sector.

Admittedly, due to the softer inflation picture we now envisage (where headline HICP may fall below 2% in H2 next year, with the core not far behind), we have also upgraded the 2024 GDP outlook, but modestly so to a 0.5% rise, compared to the 0.2% increase we envisaged three months ago. But while there are risks to this are on both sides, we feel on balance they remain are on the downside, explaining our limited upgrade and to a still below-consensus outlook. Indeed, given the unprecedented nature of the current tightening in financial conditions, it is very difficult to assess the size, timing and duration of the likely damage to the economy. Moreover, an added issue of caution is that, amid a central assumption that the Ukraine War continues to simmer over into, if not beyond 2024, energy supplies will continue to be compromised into next winter and will only materially improve in 2025 with major new global LNG exports from Qatar and U.S.

Thus, the cumulative 0.5 ppt GDP contraction we see, is already proving to be consumer-led and likely to reverse only slowly and with fragility in H2. Within this, and where households have seemingly run down excess savings; may now see negative wealth effects from housing; and are facing banks seemingly more reluctant to lend to consumers, we think consumer spending may yet drop almost a cumulative 2% by end-2023 and revive very slowly thereafter. Together with a much lower than previously expected energy import bill, the EZ current account may move back into modest surplus this year with a circa-1% surplus (half the pre-pandemic outcomes) and remaining there in 2024.

Figure 2: Monetary Policy Transmission Much Harsher this Time Around

Source: ECB, Continuum Economics

Fiscally, it does seem as if budget consolidation will be the order of the day in 2023 and 2024, unless banking sector stresses necessitate fresh government intervention. As a result the EZ budget gap may remain somewhat above 3% in 2023 and with upside risks due to the weaker growth backdrop we envisage.

ECB: Too Complacent Still?
We think that the raising of all rates by a further 50 bp this month is likely to be the last in this cycle. From here-on the ECB is now emphasizing (as should have been the case always) that policy will be data dependent, but it also seems to have (belatedly) promoted questions of financial stability towards those of inflation. Despite ECB suggestions that EZ banks are well capitalized, they are also exposed to higher interest rates that have risen at record rates in the last nine months. Indeed the deposit rate is now at 3.0% representing a cumulative hike of 350 bp which has filtered through rapidly as well into retail loan rates steadily increasing the speed and strength at which the transmission mechanism of monetary policy is biting. Indeed, in an unprecedented manner, not only is there the much greater speed and size of recent hiking but it is the fact that bank credit standards have been tightening alongside official rate increases rather than in the latter’s (protracted) wake (Figure 2). In other words, as interest rates have increased the cost of credit, the supply of credit has fallen in a coincident manner. And as discussed above in terms of what has been occurring in terms of plunging money growth and actual drops in the outstanding level of credit, repercussion are already evident and mounting.

This is why we have repeatedly suggested even the hike this month may be yet another ECB policy mistake as occurred in 2008 and 2011. Regardless, the ECB admits the policy outlook is murkier, noting the added downside risk emanating from market tensions meaning it ‘stands ready to respond as necessary to preserve price stability and financial stability’. Admittedly, it still has clear reservations about core inflation, which remains the main concern even though its updated forecast see underlying inflation ebbing toward 2% into 2025. The ECB may have stuck to its guns in suggesting that if the economy develops in the manner its baseline forecasts suggest there would be need for further hiking. But, effectively, it is taking its finger off the policy trigger at least for the time being and given that we see the ECB’s baseline being undershot as monetary conditions worsen further and banking worries persist, a policy pause from here-on is seen with risks on both sides and where any plans to move to QT are to be shelved. Indeed, official rate cuts into 2024 are an increasing likelihood and we forecast two 25 bp cut in H1 2024.

Germany: Not Immune to Financial Risks
Despite the drop in energy costs due to the mild winter and success in boosting gas stocks, Germany is now in recession, with the GDP contraction having begun last quarter even though this still led to growth in 2022 of some 1.8%. However, investment (business and construction) and private consumption have not yet reached pre-pandemic levels and shrank notably at the end of last year and may do so further in the near-term. Indeed, in spite of a recent improvement in confidence, the economy is expected to decline through H1 as energy prices for households are still increasing and government support is yet to be disbursed. Admittedly, and reflecting the slump in energy prices, GDP growth this year is likely to be a little stronger than we thought three months ago, but the 0.1 ppt upward revision will still lead to a fall for the whole year of some 0.4%. A fragile recovery in H2 will still see growth next year rise by only a round 0.5%, an outlook similar to that we saw three months ago as the more supportive costs and inflation outlook is offset by the impact of tighter financial conditions.

The easing in energy costs, the gradual easing of supply chains and overall solid corporate finances and full order books should set the stage for a resumption of investment growth later in 2023, even amid banking sector stresses. However, pressure on company margins from sharp increases in producer prices has been depressing the outlook for equipment investment, and higher building and borrowing costs will weigh on construction. More positively, the easing in supply bottlenecks ease may help exporters to unwind production backlogs and benefit from recovering global demand.

Figure 3: German Consumers Most Sensitive to Rising Rates?

Source: ECB, Changes in demand for loans or credit lines to enterprises, and contributing factors

HICP inflation peaked at 11.6% in October 2022 and has largely eased consistently since. In 2023, the pass-through of elevated wholesale energy price should be partly offset by the caps on gas and electricity prices, although the latter may unwind into 2024, delaying the anticipated demand led easing in price pressures. But the outlook has been helped by the fact that despite the labor market remaining tight, wage growth has so far continued to trail inflation and we think this will continue to be the case. Otherwise, weakness in imports this year due to weak demand will see the current account recovery back above 4% of GDP and stay there into 2024, albeit both down clearly from the 7.4% posted in 2021.

A clear repercussion of this fragile outlook, and associated downside risks, is that even the German financial system could come under considerable pressure as the Bundesbank has acknowledged. Notably, even in Germany, there are vulnerabilities stemming from the stock of loans built up in recent years. Low interest rates as well as strong growth in loans and asset prices have contributed to this. Insolvencies in the corporate sector and thus credit risk have declined in recent years: while banks still consider their credit risk to be fairly low, many of the assumptions made to date when granting loans are likely to prove to be overly optimistic. And it does seem as if particularly in Germany the rise in interest rates is becoming a more important factor in lending (Figure 3).

Fiscally, energy-related measures, and especially the “gas price break”, will prevent any meaningful reduction in the general government budget gap from the 2.6% of GDP outcome recorded for 2022. Further out, there are still ambitious climate targets based around fiscal incentives to crowd in private investments all alongside a planned but more contentious recently significant increase in military spending of € 100 bn over the next few years. But much if this will be funded through shadow budgets, the spending of which is excluded from the debt brake that has been reinstated from 2023 onwards.

France: Political Troubles Growing
Not unsurprisingly, President Emmanuel Macron’s troubled winter has turned into a troubled spring amid popular protest that has been accentuated by planned pension reforms, the latter having needed an over-ride of parliament. This is likely to mean gathering support for further planned reforms on issues such as climate change will be even harder. But despite the clear headlines about pensions, the economy is as much the source of public dissatisfaction and understandably so given the recession that may already be underway, however, modest it may prove to be.

Due to France’s relatively high domestic production of energy (mainly via nuclear), as well as what has been substantial further fiscal support to both consumers and companies, the envisaged GDP contraction may be limited to H1 this year, with a modest recovery occurring in H2. In perspective, French economic activity slowed in Q4 2022 but where the gas and electricity price shocks for businesses actually resulted in a slowdown rather than a decline, despite a sharp fall in consumption.

This relative resistance has been flagged by business surveys, but the signals sent out by higher-frequency data (eg electricity consumption by large industrial companies) has actually been more negative. Those latter surveys also suggest concerns about supply are easing, in turn moderating price (Figure 4) but those regarding demand are increasing somewhat. Regardless, while GDP increased by 2.6% in 2022, it grew much more slowly through the year (at +0.15% on average per quarter), and where such a pace is likely to slow to a crawl, or more likely turn to a modest decline in this and the coming quarter, not just due to the energy squeeze buy also due to the array of industrial actions that may extend into Q2.

Figure 4: Businesses Suggest Easing Price Pressures

Source: Bank of France, % balance regarding selling prices

This means that we see GDP growth of around 0.3% in 2023, a slightly upgrade to the flat picture we envisaged three months ago. As for 2024, there will be more recovery, but GDP growth may still be nothing more than a trend-type 1.2%, which would have been softer still save but for the clearer fall we think inflation will undergo in the coming two years. Indeed, while we have revised up the inflation outlook by 0.2 ppt to 3.7% for the 2023 average, the rate may actually dip under 2% in 2024 as wage growth is restrained partly by a rise in the jobless rate back towards, if not above, 8% in the next 18 months. However, this will add to existing pressure on household purchasing power and consumption growth, the growth in the latter is likely to undershoot that of overall GDP at least for this year. Constrained business and household confidence, weaker global economic conditions and high uncertainty will hold back investment (which soared in 2021). Exports will also slow further, with the current account deficit likely to stay around 2% of GDP as a higher energy bill prices offset weaker import volumes growth. With slowing employment gains, the unemployment rate will progressively rise back towards to 8%, all possibly curbing consumption growth a little further in 2023.

Especially given political inertia, fiscal policy is likely to be neutral in 2023 and then shift to moderate consolidation in 2024, albeit with the budget deficit staying around the circa-5% of GDP outcome seen last year. Energy-support measures are assumed to be partly phased out by 2024, with a 15% increase in regulated prices. With a budget deficit of over 5% in 2023 and with the medium-term aspiration (i.e. 2027) of 3% looking challenging, the risk is that the government debt ratio edges up a little further in the coming two years.

Italy: Risks Are So Far Being Contained
Italy has probably already dipped into recession, albeit a very modest one. However, this picture masks what has been clear and increasing weakness in terms of domestic demand, this very much accounting from the drop in GDP last quarter and the likely further small q/q falls we anticipate in H1 this year. Overall, the economic backdrop and outlook has not altered much from what we envisaged previously, this indicative of some degree of economic resilience, albeit partly a result of both the reopening of the economy (including recovering tourism) and policy measures to cushion the impact of high energy prices. As a result, after what was growth of 3.8% last year, the economy may see a largely unrevised GDP growth rate of 0.2%, this encompassing a cumulative contraction of around 0.5 ppt but which should end by mid-2023. But the recovery will be modest, albeit where consumer spending may underperform overall GDP this year, but this failing to offset the impact of rising nominal energy imports which will keep the current account in moderate deficit of just under 1% of GDP - after strong growth in the last year partly on the back of a buoyant tourism season, exports are forecast to grow more moderately in 2023, in line with softer external demand. The modest recovery will continue into and through 2024, where GDP growth may be no more than 0.8%, albeit this actually broadly in line with the economy’ admittedly subdued potential and where consumer spending may grow slightly faster.

Otherwise, high input costs, tightening financing conditions and slowing demand are projected to dampen corporate investment, although government capital spending is expected to be solid on the back of Recovery and Resilience Facility – (RRF) financed investment. However, housing investment is already weakening and may slow further, due to higher mortgage rates and the phasing out of building renovation incentives.

As ECB surveys indicate, Italian banks are reporting the clearest rise in the cost of funds and tightening in overall credit standards. Even so, to date, it is notable that even amid the recent return of banking sector turmoil, sovereign spreads have not risen meaningfully even in Italy. This is indicative of the fact that the risk of a government debt crisis is moderated as banks are (largely) in better health and the fiscal side is far less fragile in spite of the pandemic-induced jump in debt. Moreover, the government under PM Giorgia Meloni is not considering any budget laxity, albeit as much a result of internal divisions within the coalition than respect to fiscal prudence. Admittedly the current projection of a 2023 budget deficit some 0.5% higher than the 3.4% projection of the previous administration is far from invalid, it being kept in rein by RRF payments. Indeed, borrowing needs will be reduced through substantial budgetary relief from these EU funds: between 2023 and 2025, Italy can expect annual grants of more than 1% of GDP and a little more than that again through cheap loans. But the internal splits within the new government alluded to above make it unlikely to be either able or willing to push through structural reforms to address Italy’s growth weakness than any of his predecessor. This underscores that fiscal risks do remain in Italy, which may resurface should the EU reintroduce a new medium-term fiscal rule for budget deficit trajectory; should Italy suffer a major recession and/or if the ECB decided on an aggressive QT option for APP that included outright sales as well as not reinvesting redemptions.

Figure 5: Spain’s Workforce Has Hit a Record-High

Source: INE

Spain: Catching-Up Still
Spain is likely to see the fastest GDP growth of the Big 4 in 2023 and for the second successive year and where the 2022 backdrop shows an expansion a full ppt higher than we envisaged three months ago. But this out-performance needs perspective as the level of GDP has still to return to pre-COVID levels unlike much of the rest if the EZ. Regardless, while the economy has slowed as higher interest rates as well as larger domestic price pressures and a deterioration of global growth prospects hit demand, growth is unlikely to slow any further. Instead, activity rates should instead start to pick-up afresh in H2 2023., thus very much meaning that Spain should avoid recession as a continued rebound of tourism, coupled with government measures to mitigate the impact of high energy prices, are expected to help Spain partly to weather the still blowing headwinds stemming from the uncertain global and European context. In fact the tourism boost may broaden out as foreign visitors continues to complement what has hitherto been more a recovery on the domestic side – early 2023 data suggest that international visitor levels are almost back at pre-COVID levels, boosted in particular by EU flows. This is also helping the current account balance, meaning a further surplus of around 1% of GDP may be on the cards this year, despite higher nominal energy imports

Even so, after growth of 5.5% in 2022, GDP is seen expanding just 1.5% in 2023 with a slightly slower (and thus more sub-par) growth rate envisaged for 2024, the outlook for this year upgraded by 0.4 ppt from that envisaged in December.

An added support to spending power is that headline inflation has peaked and is set to fall towards 2% by end-2023 albeit base effects may create volatility through 2024, deferring a further slowing through next year. Most recently, looking as national account data does suggest that it has been profit margins as the main driving force in pushing up inflation, but that may recede as the slow-down saps pricing power. Over and beyond this anticipated fall back in inflation, which may be helped by Spain’s increased ability to source LNG, further support will come from the solid labor market. This is highlighted by an unemployment rate now just under 13% and likely to remain at his cycle low through next year, if not dip below into 2024 – this all despite what seems to be structural recovery in labor supply. However, and perhaps a result of the growth to record-levels in the labor supply (Figure 5), there has been little pick-up in wage growth and this will help restrain activity into next year as may a continued restraint from construction that is already seeing modest fall in house prices occur.

But ahead of a general election due by end-2023, more limited fiscal action seems likely, albeit not to an extent that may prevent the general government balance consolidating the improvement last year and where a gap of around 4.5% of GDP is thus seen again this year, in turn taking the government debt ratio down below 115% in 2023 and even lower in 2024. In the interim, the fiscal position is being buttressed by Spain's National Recovery and Resilience Plan is one of the biggest financed by the Next Generation EU recovery instrument.