Eurozone Outlook: Monetary Masochism

Our Forecasts

Source: Continuum Economics, Eurostat

Risks to Our Views

Source: Continuum Economics

Eurozone: Economic Clouds Getting Darker

That the EZ economy has apparently avoided recession misses the point.  Admittedly, after contracting in Q4 last year the economy has eked out small gains in the last two quarters.  But this masked a continued fall in final domestic demand and where the sizeable inventory build in Q2 GDP may be involuntary enough to undermine activity in H2 this year and/or into 2024.  Admittedly, that inventory induced Q2 GDP reading (one revised down sharply from the flash reading) has forced us to upgrade the 2023 GDP outlook, by 0.2 ppt, to an anticipated rise of 0.3%.  And the cost of this is a downgrade to 2024 GDP prospects where we see nothing more than this year’s feeble rise being repeated.  This below-consensus outlook does mask an anticipated recovery through 2024, albeit a fragile and feeble one and one that comes after a more pronounced but still relatively shallow recession in H2 this year.  

Such weakness is being flagged by business and consumer surveys and is very much also consistent with the unprecedented slump in private sector credit, all of which we think are a result of extensive ECB tightening (see below).  This has important reverberations.  Firstly, the continued domestic weakness we envisage encompasses a further drop in consumer spending, the latter still to return to pre-pandemic levels.  Undermined by fragile confidence and higher interest rates, this slump could extend into 2024, even though the current drop in spending power may dissipate into next year as inflation eases further and wages grow slightly in real terms. Secondly, other aspects of domestic demand will also restrain growth into and through 2024, not least a negative fiscal impulse as recent government support measures are reversed.  In addition, construction spending may fall more notably and broadly on a geographic basis, something also hinted at by surveys. But the domestic weakness to date has been 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.  This will also mean that the return to a current account surplus that is likely this year (at around 1.5% of GDP) may actually be partly reversed in 2024.  

Regardless there are risks, mostly to the downside, which may mean a deeper and/or longer recession that could potentially extend into 2024.  Much of these risks emanate from gauging how and when tighter financial conditions bite and to a lesser degree additional weakness in global demand.  Furthermore, mounting climate risks, where next year could see an escalation of the extreme weather conditions and unprecedented wildfires and floods seen this summer, also weigh on the outlook.  There are upside risks too, most notably around a households reducing what are still apparently elevated savings rates.  But given the manner in which household bank deposits have fallen we estimate these savings are likely to be in illiquid assets and we are already anticipating the kind of sizeable inflation fall that could precipitate a confidence-induced drop back in savings.

Notably, this domestic weakness is yet to cause a reversal in what has hitherto been a solid labor market, with a healthy rise in the workforce (actually to both higher and faster levels than pre-COVID).  But this is now occurring alongside a small rise in unemployment and where the latter may start to rise more perceptibly into 2024.    

Figure 1: Adjusted Data Suggest Core HICP inflation is Already Falling Clearly

Source: ECB, % chg

Encompassing an already softening inflation picture we still envisage headline HICP moving below 2% in H2 next year, with the core not far behind, our projections unchanged from three months ago.  Notably, there are already signs of softer core or underlying inflation, most notably in persistent price measures as well as in recent seasonally adjusted m/m swings (Figure 1).  There are also some signs of slower wage inflation, the latter possibly a reflection of increased labor supply. 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 demand and thus how depleted spending power may rein in pricing power.  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.

Fiscally, it does seem as if budget consolidation will be the order of the day from hereon. The fiscal stance is projected to be neutral in 2023 but to tighten in 2024 mainly on account of the withdrawal of almost 75% of the energy and inflation compensatory measures from the last two years.  As a result the EZ budget gap may drop from a little above 3% in 2023 to a little under in 2024, but and with upside risks due to the weaker and fragile economic outlook backdrop we envisage.

Figure 2: Stronger Monetary Policy Transmission Poses Clear Downside Risks

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

ECB: Another Policy Error Beckoning?

As suggested above, 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 and to the highest level since the ECB was formed. However, also unprecedented is the fact that credit standards have been tightening alongside and not with a long lag as in previous cycles (Figure 2). Furthermore, conventional hiking is being buttressed in an unprecedented manner by the reduction in the ECB balance sheet (TLTRO runoff as well as APP QT) which has acted to reduce bank deposits. All of which underscores, if not accentuates, our long-standing  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.

With this in mind, we think that the persistent and sizeable rate hikes that have occurred at each of the ten Council meeting since July 2022 may now be paused with what was a valedictory further hike of 25 bp taking the deposit rate to 4.0% earlier this month.  The impact of its tightening is recognized by the ECB to some degree not only by the splits over the decision, but in both belatedly noting the transmission mechanism is working faster than in previous cycles and that credit supply is being restricted.  Thus we were not surprised that the ECB is hinting that rates have peaked nor by the ECB having pared back its economic growth projections (significantly for 2024), albeit to rates which we feel are still too optimistic.  Regardless, even with it seeing inflation seen back at target in H2 2025, the ECB has retained a tightening bias and implies no early easing even though it has maintained a predisposition that it will be data dependent.  However, with this in mind, we still think ECB rates may start to fall by Q2 next year, as ever worsening real economy prospects materialize and force the ECB to revisit its over-optimistic economic outlook.

The question therefore is whether the downside real economy risks are now actually or at least starting to take precedent over the ECB’s clear worries about prices particularly core inflation.  This may reflect increasing Council splits with worries about overdoing tightening, with the memories of previous policy mistakes, most recently the two short-lived hikes in 2011, still evident.  It has been long argued that the effects of past rate hikes have not yet been fully transmitted to the real economy. As suggested above, it is now admitted that the transmission mechanism is working faster than in previous cycles, this being a belated recognition of something we have been stressing for some time.  Indeed, this is very much a focal point of the downside risks we envisage. Slumping, money supply numbers are a symptom of EZ real economy risks which may now be materializing.  All of which is a reflection of the sizeable monetary tightening  (both conventional and unconventional) the ECB has presided over in  the last 14 months and which its own models suggest will only have the most pertinent impact through the coming 12-18 months! In other words, as interest rates have increased the cost of credit, the supply of credit has fallen in a coincident manner.  All of this will likely translate into inflation slowing more than the ECB expects, with worries that inflation could then undershoot target causing ECB rate cuts from Q2 2024 – we see 75 bp of cumulative easing in 2024.  

Germany: Cyclical and Structural Headwinds?

The likely drop in 2023 GDP that we flagged three months ago is now being accepted by consensus thinking as is the fragile and weak recovery that is likely into 2024.  Admittedly, we have pared back the expected GDP drop this year to -0.4%, but the 0.2 ppt upgrade is exactly offset by the downward revision we have made to 2024 prospects, where the below-consensus 0.3% rise will not even repair the damage seen through 2023.  But alongside the belated recognition of the extent of Germany’s economic malaise is an acceptance that it is far from purely a cyclical development, this being vital in assessing the prospects beyond this year and especially for 2024.  In June we highlighted the structural factors hitting the economy, including vulnerable supply chains, relatively high energy costs and adverse 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 this made worse by the low and falling aggregate hours worked by the average German employee (Figure 3). Moreover, concerns continue over the government’s decision to support certain industries such as semiconductors and construction, via large direct subsidies and tax breaks, over more traditional sectors such as chemicals, which are suffering badly from the rise in power costs.  In addition, Germany’s industrial success is also under threat from China both from the slowing in the growth rate of the latter and from increased competition, most recently in producing electric vehicles.  Topically, this is something that has stoked up a diplomatic skirmish between the EU and China. In contrast, some sectors — chiefly defense — are experiencing unprecedented demand, as the war in Ukraine has boosted military spending across Europe.

Regardless, Germany is now in recession, with the GDP contraction likely to persist, if not deepen afresh through H2 this year and with little momentum emerging through 2024.  ECB policy is biting ever more clearly, although we see some respite as inflation has peaked and we see it falling further and actually reaching 2% by end-2024.  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.  Notably, with imports set to recover, after reaching just over 5% of GDP this year, the current account may only stay there in 2024.

Figure 3: Potential Output of Germany’s Economy Hurt by Low and Falling Hours Worked

Source: OECD, average hours worked annually

Although doing little to address structural issues such as infrastructure inadequacies, the government has set out what it calls a 10-point plan to boost the economy in the medium-term, mainly via cutting so-called ‘red tape’.  Regardless, the budget deficit is likely to fall again next year from just under 3% of GDP in 2023 towards 2.5% as the volume of temporary support measures continues to decrease. However, projected funds particularly in terms of longer-term initiatives on climate policy and defense is rising sharply and this may be accompanied by state and local government budgets remaining somewhat expansionary in the year ahead.  As such and given the commitment to the debt brake that has been reinstated from 2023 onwards, there seems little being done to address these structural issues.

France: Harder Times Await

The relative economic resilience seen of late, save for hamstrung construction, seems to be dissipating.  This is very much what business survey data seem to be suggesting: the INSEE-compiled business climate has dipped below its long-term average for the first time since April 2021.  We think this spells near recession in H2 this year, which will create an adverse carryover for 2024.  As a result, weak and below consensus growth rates of between 0.6% and 0.7% are seen this year and next respectively, the latter a clear downgrade on our view of three months ago.  Admittedly, this may disguise a somewhat better underlying rate for later in 2024, but this comes with downside risks as the economy tries to weather the rise in interest rates and the economic uncertainty that has clearly perturbed the French consumer. Notably, while household purchasing power has been preserved thanks to government support measures, moderate wages and a favorable labor market, private consumption remains weak and may even dip this year as households maintained an exceptionally high saving rate, this a result of very low confidence readings.  This does provide scope for spending to pick-up in 2024 but we think that much of the savings are locked up in illiquid assets and reflects wealthier households with a lower spending bias, so the boost will be modest and that consumer spending will grow no more in 2024 than overall GDP. Investment from both households and corporations is projected to recover progressively into 2024 but only after fresh drops in coming quarters. Meanwhile, over the forecast horizon, net exports are set to have a minimal and possibly negative contribution to growth. Export growth, which traditionally relies on a few specialized sectors such as aeronautics and other transport equipment, is expected to be offset by rising imports mirroring the recovery of household consumption. Hence, a still clear current account gap will persist into next year, albeit staying at around half the 2% 2022 outcome.

Even so, the economy and particularly the consumer side, is as much the source of public dissatisfaction both in terms of weak activity and price pressures.  But inflation has fallen and is likely to do further and perhaps on a more core basis into 2024.  Although we have raised the projection slightly, we still see CPI inflation averaging as low as 2% next year.  This is backed up by business surveys also suggesting even more clearly that retail trade price pressures, while lagging those of industry are set to fall further in the short-term, 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 back towards 8% into 2024 and where companies are likely to see profit margins fall.  

Figure 4: Broad Array of Businesses See Easing Price Pressures 

Source: INSEE, Balances of opinion on changes in selling prices over the next 3 months

Regardless, fiscal risks are evident.  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. With a budget deficit of over 5% of GDP in 2023 and with the medium-term aspiration 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 earlier this summer.  We also remain concerned about the sharp debt build-up since 2007 (here).  Fiscal worries could easily resurface!

Italy: Fiscal Side Back in Focus

It now seems to be the case that consensus thinking is moving down to mirror our more long-standing relative gloom about the Italian real economy.  Partly this reflects the fact economic growth started slowing last year, and after a pick-up in early-2023, GDP decreased by 0.4% q/q last quarter, driven by falling domestic demand, as the phasing out of the extraordinary incentives for building improvements during the pandemic. But negative economic signs have continued into this quarter, enough to flag a formal recession and enough to depress growth next year even more than we envisaged three months ago.  Indeed, we still see GDP growth of 0.8% in 2023 but see a weaker outlook for next year of 0.6%, entailing a 0.2 ppt downward revision.

Consumer spending has and will continue to be held back by weak, if not falling, real disposable income.  A very gradual increase in nominal wages, together with less positive employment conditions, will keep private consumption growing by less than GDP into 2024, with activity undermined further by the planned expiry of all temporary income-support measures. Capital spending is now contracting and may pick up only moderately in 2024, as the fall in housing construction is offset by RRF-supported increases in investment in infrastructure and equipment. Net exports may provide a little support to growth in 2024, following a likely positive contribution in 2023, but where the return to a current account surplus this year will at best be consolidated next year.  All of which will pull inflation down clearly into 2024.  Indeed, HICP inflation is projected to moderate from 6.3% in 2023 down to 2.0% in 2024, the latter revised up slightly on the back of the latest recovery in energy prices. Higher average consumer prices are expected to pass through into labor costs only partially and with a substantial lag partly due to the long duration of wage deals and also due to an Italian-specific indexation of contractual wages to a measure of inflation that excludes the impact of imported energy inflation.

But of course higher interest rates are the main negative, enough to have triggered overt ECB criticism from a government where policy priorities may be changing. When coming to power less than two years ago, PM Meloni pursued a fiscally prudent stance, largely continuing those put together by the previous (Draghi) administration.  It now looks likely that the upcoming 2024 budget, to be unveiled shortly, will be of different nature, accepting, if not accentuating, fiscal slippage.  Partly this will be cyclical as the current official growth projections of 1.0% this year and 1.5% next year are widely seen as over-optimistic.  The question is whether the government can still meet its target of reducing its fiscal deficit to 4.5% of GDP in 2023, and 3.7% in 2024, or whether the government will increase the deficit target partly reflecting scaled back 2024 growth assumptions, probably chiming with those recently made by parliament. One key component will be the extent that Italy continues to benefit from the EU-funded COVID recovery plan, amid a fiscal backdrop of having already had to dilute plans to levy a windfall tax on banks that has still triggered overt criticism from the ECB and perturbed financial markets, albeit with sovereign spreads still seem to be under control.  Most likely, and amid reports of much higher fiscal shortfall due to the one-off impact of the so-called Superbonus, (where property owners tax credits for energy-related home improvements), the government may point to after admitting to a budget gap near 5% this year.  More market scrutiny will be on the beyond-2023 picture where a projection gap around 4% is envisaged for 2024 and to 3% in 2025.

Figure 5: Projected Debt-to-GDP Ratio Gross and Net of EU Aid

Source: Italy Government, Bank of Italy and ISTAT

This underscores that fiscal risks do remain in Italy, which may resurface 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: Politics Unresolved

The solid economy continued into the last quarter and has been upbeat enough to warrant a 0.2 ppt upgrade to the 2023 GDP picture to 2.5%.  But there are clear indications that growth is slowing, most notably in business surveys, and to a degree that a near-recession may be on the cards for H2.  This will set an adverse base for 2024 where a modest recovery in activity may still pull GDP growth down to just 1%, a below consensus reading and one that is some 0.2 ppt lower than envisaged three months ago.  This will reflect an array of factors, not least the fading impetus of the bounce in tourism so far this year.  There is also the impact of both weaker global demand and tighter financing conditions both likely to trigger softer labor market dynamics into and through 2024. Notably and in contrast to the weaker overall 2024 picture, improved households’ purchasing power may pull up consumption, but only from a very anemic 2023 performance. However, lower leverage of the private sector achieved in recent years and the further implementation of the RRP is expected to continue supporting investment growth into 2024.

Tourism has also helped the current account balance, meaning a larger surplus of around 1.5% of GDP may be on the cards this year, despite higher nominal energy imports but with the recovery in consumer spending may reduce the surplus in 2024.  As for inflation, this is set to fall towards if not through 2% by end-2024, though base effects may create volatility through next year. Although it may soften, an unemployment rate now just under 13% is likely to remain at this cycle low through next year, 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 clear falls in house prices occurring.

As for politics a fresh election, probably in the New Year, is still highly possible.  Indeed, if opinion polls continue to show improved ratings for his party, PM Sánchez may eschew a potentially radical and divisive constitutional move, to win the support of Catalan nationalist to prop up his minority administration.  But there is also a chance that the opposition People’s Party (PP) may form a government. While political uncertainty is expected to have a limited economic impact, it could delay the implementation of the Next-Generation EU funds. But this should not derail a drop in the government debt to GDP ratio that next year should be some eight ppt below the peak of 120.4% set in 2020, and where recent GDP upward revisions may lead to an even lower debt profile!