Eurozone Outlook: Import(ant) Downside Risks

Our Forecasts

Source: Continuum Economics, Eurostat

Risks to Our Views

Source: Continuum Economics

Eurozone: Modest Recession Masks Deeper Domestic Downturn

Starting with the good news; the EZ economy has apparently seen continued resilience despite what now is the fact that a formal recession has been the order of the day in the last two quarters.That recession has been modest with 0.1% q/q dips in each of the quarters but this masks a much greater weakness in domestic demand worth a cumulative drop of almost 2 ppt in that period. This weakness is also being hinted at in the unprecedented slump in private sector credit.This has important reverberations.Firstly, and especially as this domestic weakness encompasses a 1.3% slump in consumer spending, it is likely to reflect a drop in spending power from higher inflation that may increasingly act as a drag of pricing power – with even the ECB having acknowledged of something we have flagged in terms of the impact of company profit margins in supporting, if not, boosting headline HICP inflation. Secondly, that domestic weakness was masked by a fall in imports (not least in energy related purchases) which may already be reversing, thereby acting to suppress any recovery in overall GDP in H2 and then into 2024. All of which persuades us to think that GDP will move sideways for the rest of the year and only start a fragile recovery going into 2024.

It is against this backdrop and outlook that means we underscore downside activity risks ahead and a reluctance to alter our very much below-consensus GDP projections.This is despite the on-going fall back in energy costs versus last summer, helped by a sharp fall in gas consumption and continued diversification of supply sources, including recourse to new LNG supplies with the added support coming from a further easing in supply issues. Thus we still see only a meager rise in GDP for this year of 0.1% and little better of 0.4% for next year, these being in line with our thinking of three months ago, but also reflective of different national economy dynamics (see below).

Notably, this domestic weakness is yet to cause a reversal in what has hitherto been a solid labor market, with the healthy rise in the workforce (actually to both higher and faster levels than pre-COVID) now occurring alongside a slippage in unemployment, but where the latter may start to reverse in H2.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: Stronger Monetary Policy Transmission Poses Clear Downside Risks

Source: ECB, Continuum Economics; BLS is bank lending survey 

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 (Figure 1). However, credit standards are tightening as well and that conventional hiking is being buttressed in an unprecedented manner by the reduction in the ECB balance sheet (see below). But there are now broader signs that policy is biting in a potentially more adverse manner, all posing serious downside risks for real and nominal activity. All of which underscores our on-going premise that while the shock to the EZ economy from energy may have diminished it is being replaced by a monetary one in which financial conditions have tightened rapidly and broadly.

Encompassing an already softening inflation picture we still envisage headline HICP below 2% in H2 next year, with the core not far behind. Admittedly, there have been some signs of faster wage inflation, alongside high(er) company profit margins.Negotiated wage growth had increased strongly though last year and into Q1, but has been boosted by one-off payments that are unlikely to be repeated.Moreover, survey data (Indeed’s high-frequency job postings indicator) has if anything suggested that wage pressures have moderated of late, something we feel will continue given the even-harder financial backdrop companies are facing and the reduced inflation expectations that households are signaling. Admittedly, 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 0.3 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 over a cumulative 1% 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 a larger surplus this year with a circa-2% of GDP projection taking it back to pre-pandemic outcomes) and remaining there in 2024.

Figure 2: Unprecedented Fall in Level of Deposits and Credit

Source: ECB, Continuum Economics, € bln

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: Increasingly Complacent?

We think that the raising of all rates by a further 25 bp this month (here) is now likely to be followed by another such move but that is likely to be the last in this cycle.From here-on the ECB is emphasizing (as should have been the case always) that policy will be data dependent, but it also seems to have (belatedly) promoted questions of the strength of the monetary transmission mechanism 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 12 months. Indeed, the deposit rate at the 3.75% rate we see next month would represent a cumulative hike of 425 bp.But the increasing speed and strength at which the transmission mechanism of monetary policy is biting, is unprecedented and also reflects the fact that bank credit standards have been tightening alongside official rate increases rather than in the latter’s (protracted) wake. In addition, the ECB’s shrinking of its balance sheet, mainly from reversing TLTROs has seemingly led to an unprecedented drop in bank credit levels, something that may have accentuated the equally unprecedented drop in the level of private sector credit (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 in terms of what has been occurring in terms of plunging money growth and actual drops in the outstanding level of credit, repercussions are already evident and mounting.

In addition, the global backdrop is weaker than the ECB has been hoping for, particularly China. This is why we have repeatedly suggested even the hike this month, let alone the looming July, move may be yet more ECB policy mistakes to contend with those in 2008 and 2011.Regardless, the ECB has clear reservations about core inflation, even though its updated forecasts see underlying inflation ebbing toward just above 2% in late-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. Given that not just money and credit data are flagging (seemingly growing) downside risks, but survey evidence too, all implying some continued degree of complacency from the ECB. This to us implies that the ECB will face downside surprises but not fast and clear enough to avert the further hike that President Lagarde very much pointed to for the July 27 meeting. But that probable further 25 bp hike should be the last in the cycle, despite no clarity regarding any potential terminal rate, save that it will restrictive. Rate cuts next year are still likely and we forecast a cumulative 75 bp reduction starting in Q2 2024. 

Germany: Structural Headwinds?

Despite the continuing 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 at end of last year even though this still led to growth in 2022 of some 1.9%.Against a backdrop where manufacturing signs are softening; where still high inflation is eroding spending power and where ECB policy is biting ever more clearly, we see GDP contracting modestly further in this and the coming quarter. Inflation has peaked and we see it falling further and actually reaching 2% by end-2024. Regardless, the recovery will be weak and fragile into 2024.As a result, we have actually downgraded the 2023 GDP projection by 0.2 ppt to a 0.6% drop, retaining the feeble 0.5% 2024 recovery as the more supportive costs and inflation outlook is offset by the impact of tighter financial conditions. Within this, consumer spending is likely to fall too this year but where domestic demand weakness is likely to see the biggest damage emanating from the slumping construction sector. Indeed, building activity is falling increasingly and broadly, albeit led lower by residential construction work, and where surveys very much suggest that difficult conditions will persist for at least the coming year, amid a backdrop of rising interest rates and uncertainty.Notably, this domestic weakness, alongside reduced energy usage, is curbing imports although with exports also soft due to manufacturing fragility, the current account may remain just under 4% of GDP this year and only rise above in 2024.

In this regard, German industry is indeed facing significant structural challenges, some accentuated by cyclical factors that are already undermining potential as well as actual growth (Figure 3). First, supply chains remain vulnerable, although there have been clear improvements.Second, despite recent corrections, energy costs remain high both historically and relatively.Despite the recent softening in energy prices, both these factors are evidently triggering some fresh relocation of production abroad.But there is further factor in the form of demographics. Strong labor market-oriented net immigration has more than offset a decline in the domestic workforce, with the influx from Ukraine having played a major role of late. However, from here-on, net migration will probably no longer offset the effects of the decline in domestic workforce.

Figure 3: Energy Costs Reduce Immediate Potential Output of Germany’s economy

Source: Bundesbank

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. 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. But a fall to well below 2% beckons next year. 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: Fiscal Issues Building

With the exception of the construction sector (which has contracted in each of the last four quarter), the economy has shown some degree of resilience.Even so, the economy is as much the source of public dissatisfaction as the much vaunted pension reforms and understandably so given that GDP has risen a bare 0.4% in the last year.Similar modest growth may be in store of the whole of this year, albeit with the better-than-expected Q1 reading prompting a modest (0.2 ppt) upward revision to the 2023 GDP outlook to 0.5% compared to what we envisaged three months ago.But the weak underlying picture remains in place and is highlighted by an unrevised and slightly below-trend 1.2% 2024 projection.This is consistent with current survey data which highlights that companies have excess inventories and flat order books. As a result, GDP is likely to slow to a crawl, or may even see a modest decline in this and/or the coming quarter, with the array of industrial actions that may extend into Q3 not helping.

Very much high inflation undermining spending power has been the main cause of recent activity weakness which has seen consumer spending dip in the last four quarters and where a flat outlook for the latter is the best that can be expected for this year.But the impact of high prices on spending will persist even though inflation is likely to subside as surveys very much indicate may already be occurring on a broad basis across sectors (Figure 4).Indeed, while we have revised up our CPI projection for this year, we still see the rate falling below 2% in 2024, this reflecting the direct impact of falling energy prices, which may be more marked in France due to the relatively high domestic production of energy (mainly via nuclear). In addition, business surveys also suggest even more clearly that concerns about supply are easing, something that suggests that core inflation is likely to recede similarly.All of which reflects the growing impact of tighter financial conditions which are likely to lead to a rise in the jobless rate to above 8% into 2024 and where companies are likely to see profit margins fall.

Figure 4: Broader Array of Businesses See Easing Price Pressures

Source: Bank of France, % balance of companies that increased selling prices, by major sector

As for the rest of the economy, construction weakness will persist in to 2024 while, weaker global economic conditions and still elevate uncertainty and tighter financial conditions 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 despite weaker import volumes growth. 

Regardless, fiscal risks are increasing.Especially given political inertia, fiscal policy is likely to be neutral in 2023 and then shift to only moderate consolidation in 2024, so that the budget deficit may stay around the circa-5% of GDP outcome seen last year. Energy-support measures currently worth some 2% of GDP are assumed to be partly phased out by 2024, With a budget deficit of over 5% of GDP in 2023 and with the medium-term aspiration (i.e. 2027) of 3% looking challenging, the likelihood is that the government debt ratio rises further in the coming two years.Indeed, fiscal worries, reflecting slow growth, and a sustained policy impasse exacerbated by social unrest, has already led to the country’s debt rating being cut only last month.

Italy: Clear Downside Risks

It is ironic that it is in Italy that the largest GDP upward revisions of any of the Big 4 has been made.Indeed, compared to our thinking three months ago we see 0.8% GDP growth this year, four times the previous estimate.But this upgrade does not change the picture in any meaningful manner.The upgrade is the result of a much better than expected 0.6% q/q Q1 GDP outcome which we regard more as an aberration that a charge of trend.Half of the jump was consumer related, but this partly reflected a further drop in savings rates which at the end of 2022 were already down some 3 ppt below pre-COVID levels.We see little prospect of further falls especially as the recent recovery in consumer confidence looks fragile and may be reversed as fiscal support measures unwind from H2 this year.In particular, banking data has very much highlighted a marked slowing in household credit growth to low single digits and where survey data very much suggest that demand is the main softening factor and reflective of the impact of rising interest rates.Thus we see consumer spending dipping in this and/or the next quarter, and its growth rate this year undershooting that of overall GDP.But the immediate omens for business investment are bleaker, with survey data suggesting banks are getting warier and have tightened credit standards clearly of late.This may help explain why company credit growth has turned negative, this in turn helping explain the clear slide in industrial production seen so far this year. 

These growing downside risks, if not actual developments, and reflective of a broad and sizeable tightening in financial conditions, are clear in various economic survey data (Figure 5). They are the reason why we have stuck to our modest, albeit circa-consensus 2024 GDP outlook of 0.8%, albeit this actually broadly in line with the economy’s admittedly subdued potential. But the risk balance has now tilted to the downside. Indeed, import weakness in the last two quarters has added a full ppt to the GDP backdrop. This is likely to reverse, or at least will not continue, in turn keeping the current account in moderate surplus of just under 1% of GDP. The risk outlook also points to inflation falling further and through 2024 but is a result of the combination of lower energy prices, tighter financial conditions and mildly restrictive fiscal policy. As for the latter, fiscal savings from the phasing out of crisis support and other fiscal tightening measures, amount to about 2% of GDP in 2023. This is partly offset by the expected ramp-up of spending related to Next Generation EU by about 1½ per cent of GDP. All of which may take the budget gap under 5% this year from around 8% in 2022. While this has helped continue (alongside temporary high nominal GDP in 22 and 23) the drop in the government debt to GDP ratio, further consolidation will be needed next year and beyond. So far the current government has pursed fiscal caution but there are risks of the downside activity risks do occur, one reason why the country’s already low credit rating has come under increased scrutiny.

Figure 5: Downside Growth Risks Being Flagged

Source: Bank of Italy and ISTAT

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.

Spain: Risky Election

The solid economy does not seem to be boosting the government, which has still called a snap general election for July 23 for fear of its already lagging poll standing eroding in the months ahead.Notably, Spain is likely to see the fastest GDP growth of the Big 4 in 2023 and for the second successive year and we have upgraded this 0.3 ppt higher than we envisaged three months ago to 1.8%.But this out-performance needs perspective as the level of GDP may only now be returning 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 rates should instead start to pick-up afresh in H2 2023, partly as lower inflation helps support spending power and a rebound of international tourism continues. In regard to the latter, Spain's tourism sector rebounded strongly in 2022. Even so, international tourism remains some 15% below pre-pandemic levels, implying clear scope for further recovery. There are still some headwinds in terms of international tourism. Spain's main source countries, the UK and Germany, are suffering recession like conditions. In addition, unfavorable exchange rates are also discouraging UK travelers.But there are offsets, not least that business travel has been recovering in the last few quarters helped by the resilience in the Spanish economy and this should continue into 2024. Overall, a further recovery of the tourism sector will play a central role in boosting GDP growth this year and next, given that tourism's total contribution to Spanish GDP is around 15%.Even so, a slightly slower (and thus more sub-par) GDP growth rate envisaged for 2024, and with the 1.2% rate in line with the estimate of three months ago.

Tourism is also helping the current account balance, meaning a larger surplus of around 2% of GDP may be on the cards this year, despite higher nominal energy imports.More specifically on inflation, this is set to fall towards 2% by end-2024 albeit base effects may create volatility through next year. Over and beyond this anticipated fall back in inflation, which may be helped by Spain’s increased ability to source LNG, further support to GDP 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, 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.

As for the election, in what some may say is an audacious move, Spanish Prime Minister Pedro Sánchez called a snap general election for almost six months earlier than officially scheduled. After a series of poor local election results for his Socialist Party, but particularly for his more left-wing collation allies, his gambit is to forestall a possible landslide victory by the right and the far-right forces that polls suggest may be building if not punctured soon. But a decisive election result is very unlikely, implying protracted political uncertainty through H2.But this should not derail a drop in the government debt to GDP ratio that this year should be some five ppt below the peak of 120.4% set in 2020!