Western Europe Outlook: Valedictory Hiking?

Our Forecasts

Source: Continuum Economics, Office for National Statistics, Eurostat, Swiss Secretariat for Economic Affairs, Statistics Norway

Risks to Our Views

Source: Continuum Economics

We still see fully-fledged recessions in all but Switzerland but they are now envisaged to be shallower and shorter than previously thought due to a friendlier energy and inflation outlook. In this regard, it is clear that higher prices have damaged the consumer and overall activity outlook not only via the direct impact on spending power but also because of the inter-related hit to consumer confidence which remains near all-time lows in many cases (Figure 1).Indeed, even in Switzerland where inflation is currently so much lower, and so is the central bank policy rate, consumer confidence readings are as weak as in those rest of Western European economies. But the added risk now is that of the monetary policy tightening that has continued in the last few months. It has triggered the latest flare-up of banking stress but is also causing financial conditions tightening across the board, but probably most notably in Sweden given the economy’s greater sensitivity to interest rate swings. Otherwise, it is clear that already-evident corrections in house prices have affected consumer sentiment and which may add to the erosion in consumer fundamentals via negative equity and wealth effects and reduced spending related to moving properties.

Figure 1: Consumers Still Fragile Across All Countries

Source: Datastream, Consumer confidence measures

UK: Some Resilience But Risks Remain

In terms of both business surveys and even from real activity data in the early part of this year, there are signs of resilience if not recovery. The outlook is indeed improved by the marked drop in wholesale energy prices which will filter through to households from Q2, but particularly in H2 and the fiscal backdrop this year is going to be little more supportive that previously envisaged. But we are still wary about the economic outlook not least as businesses will lose much of the energy support cushion in the near-term.But the main concern is the impact of the tightening in monetary policy that is already causing tighter financial conditions that will bite the economy through the credit channel increasingly and with added downside risks should banking sector stresses intensify. As a result, while we have upgraded the activity outlook, we still see a recession (albeit of modest proportions and confined to H2 this year) and continue to envisage what will be moderate and fragile recovery in H2 and into 2024.Admittedly, this encompasses a drop in GDP of 0.5% in 2023, this being a marked contrast to the 1.2% slump we envisaged back in December and where we now see the drop this year being largely repaired in 2024, in spite of some fiscal tightening scheduled for next year and beyond. This fragile outlook is very much led by the consumer. In perspective, this will involve consumer spending slumping by 1% in 2023 and slipping a little further in 2024, albeit projections also revised higher of late due to the fall in energy prices and ensuing softer inflation outlook. Furthermore, there will be far less support, if not outright damage, from the housing market, with the risk of an even clear correction in house prices and certainly in turnover with this threat exacerbated by what seems to be bank’s increasing wariness to lend to households.

This consumer weakness will help curtail imports but the latter will still be supported by the need to soften supply constraints and also maintain food and fuel supplies, while Brexit related distortions and a slower global economy weigh on exports. As a result, the marked rise in the current account deficit seen last year (to around 5% of GDP) will unwind modestly, with a gap of 4% still on cards by 2024.This will be part of a double-deficit as government borrowing (likely to be around 6% in the fiscal year that this month), will still be well over 4% at least until the fiscal tightening measures fully kick in 2025, in turn preventing the government debt ratio from falling.But solid imports will act as a safety-valve in helping restrain domestically generated inflation, some coming fromtight labor market, albeit the latter likely to unwind as the jobless rate climbs back towards 5% into 2024. The combination of the above will bring CPI inflation down sharply, now led lower by energy and this causing the revised CPI outlook where we now see a rate of 2.3% in 2024 (0.5 ppt lower than seen three months ago and lower still thereafter).

Figure 2: Credit Standards Tightening Courting Clear Risks to Activity

Source: BoE, ONS

As for the BoE, in what was the 11^th successive policy move, but this time with a smaller 25 bp increase than seen in recent months, the MPC met most expectations in taking Bank Rate to fresh 14 year high of 4.25% this month. Certainly not calling a peak in the hiking cycle, the BoE continued to offer only conditional policy hints. However, we note the BoE acknowledgement that, amid recent banking sector developments, bank wholesale funding costs have risen, and suggestions that services and wage inflation have been below its expectations envisaged last month as hints of policy reflection. Regardless, we still think policy has peaked, and as suggested above, we are concerned that rate hikes have already caused a growth-damaging tightening in financial conditions (Figure 2) that may look even more worrisome when the BoE unveils its next Credit Conditions Survey on Apr 13. Hence, why we adhere to rate cuts starting early in 2024!

Sweden: Recession Underway?

Notably, the political backdrop remains in a state of flux, made all the more uncertain as Sweden’s bid to join NATO continues to languish, a sharp contrast to that of Finland.Even so, providing something of a modest further fiscal boost, higher defense and energy cushioning spending is on the cards this year and probably beyond. This may still leave Sweden with a further but very modest budget deficit this year as it refrains from respecting the budget surplus rule but with a gap no higher than 0.5% of GDP envisaged out to 2024.

Regardless, the economy is in recession, not just a result of the marked fall seen in GDP at the end of last year but also given the evidence so far into early 2023, not least still very sobering business surveys (Figure 3) and now allied to signs of a softening labor market.This weakness is nothing compared to the very fragile consumer surveys which remain near all-time lows and are indicative of the damage that soaring inflation has done to spending power but increasingly the impact of rising interest rates feeding into mortgage debt servicing.Mortgage rates have risen sharply over the year and may rise further. Unlike many other economies, a large share of the mortgage stock (up to 80% in fact) is tied to variable interest rates which means that rising interest rates have a rapid impact on households’ interest expenditure and thus on their consumption which has only just started to weaken. We see a clearer hit through 2023, reflecting a drop in household real disposable incomes already around 4% y/y as well as increased caution by banks in lending to consumers. The question is to what degree it may compromise bank’s asset base.

But the continued risk is that an inter-related cooling in the housing market (with prices ultimately dropping 15%) will exacerbate existing weakness in consumer spending and to a degree that has means the latter may fall by over 1% this year.This has triggered a clear downgrade for GDP this year to -0.8% (vs -0.2% envisaged in December).This will incorporate falls in activity until at least Q4.There will be recovery, but it will bemodest and fragile, and which will also reflect unsurprising continued weakness in residential investment, this will be weak enough to restrain the expected overall GDP recovery through 2024 so that the latter’s growth rate may still be less than 1%, ie half the decade long average pre-pandemic. But exports will also fare less well into and perhaps beyond 2023, albeit with the current account surplus possibly rising towards 4% of GDP by 2024 due to weaker imports.All of which will result in an output gap of over 1% appearing through 2023 and possibly getting larger through 2024!

As for energy costs, they may be coming down but CPI data have not only surprised on the upside of late but core measures are yet to peak, this explaining the higher (6.5%) forecast we have for this year.But we still think the weak economy will take toll on prices and still see CPI inflation receding clearly towards, if not below, the 2% target by late-2023.

As for the Riksbank, it hiked its policy rate by 50 bp to 3.0% last month, despite still suggesting that inflation would return to target and stay there in the latter part of its 2-3 year forecast horizon. Indeed, its updated forecasts suggest further hikes of at least 25 bp could arrive at the next meeting in April and then suggesting that policy will be on hold until at least end-2025.  But given the failure of price pressures to recede yet, a hike of 50 bp is seen next time around unless banking sector stresses intensify.Market thinking envisages even more hiking, but on a short-lived basis, something with which we concur to some degree as we see rate easing early next year.

Figure 3: Swedish Growth Risks to the Downside

Source: Stats Sweden, National Institute

Switzerland: SNB Too Confident? 

There are more shadows overhanging the Swiss economy, now emanating domestically as the Credit Suisse furor bubbles on the back burner. The Swiss authorities suggest that the possible crisis has been contained, with the SNB openly of the view that the Credit Suisse-induced reverberations have been fully addressed as it stressed measures that were announced in mid-March have put a halt to the crisis. We think such thinking is premature at best as the recent banking sector ructions are at least partly a result of rapid policy tightening that will affect an economy already showing fragility and to a degree where GDP last quarter was flat, this masking more marked weakness in the domestic economy led by a continued slump in construction.Admittedly, the drop in global energy prices should boost spending power, but inflation near-term may be a little higher than previously expected. Together with global risks and the likelihood that banking sector stresses may affect consumer confidence further in due course we are still cautious on the growth outlook.Thus the recent slowing is likely to persist, with fiscal policy retrenching, albeit to a degree where recession is possible but not our central outlook and where even with some recent bounce in business surveys pointing to nothing more than an economy moving sideways (Figure 4). On balance, we adhere to our (December) GDP projection for 2023 of 0.5%, this broadly in line with consensus but half that of recently upgraded SNB thinking which.But reflecting what we think will be an insipid EU recovery in 2023 and beyond, we envisage nothing more than a return to trend type growth for 2024 of 1.3%.

But the main support to growth is the modest manner in which inflation has risen through the last year, and where it may have turned. This modest inflation picture does not reflect a still-strong Swiss Franc but instead stems from both what is still clear spare capacity in the economy but mainly due to the Swiss consumer (compared to the EZ) facing a vastly different shopping basket.There are risks, some reflecting that the current almost flat trend in food price inflation is forced (very much) higher by global forces, although this threat seems to be receding.But the risk of property slump is still a very real one. Partly these are offset as, for the coming year, a solid labor market, and a reduction in the high saving rate of households will support consumption.

Figure 4: Swiss Activity Moving Sideways

Source: KOF, Datastream

The SNB continued policy normalization this month In what seems to be a confident, but may be more a complacent assessment, suggesting as discussed above, it has solved the banking stresses (at least for Switzerland), the SNB met market expectations and raised its policy rates by a further 50 bp to 1.5%.The policy rate has now been increased a cumulative 225 bp since tightening began last June.While we regard this move as being the last in the cycle the SNB is leaving options open, still suggesting that it cannot exclude more hikes and also sticking with an inflation outlook that leaves the target missed by a notch at the end of the 2-3 horizon. In particular, we are puzzled by the factors underpinning this view not least the more upbeat SNB economic outlook for this year with GDP growth forecast doubled to 1%, that would necessitate q/q growth averaging 1.5% annualized, ie above Swiss trend growth 

Norway: Stunted Recovery Still Envisaged

The economy surprised on the upside in late 2022, meaning that GDP grew by 3.8%, 0.4% higher than previously assumed, also creating a more positive base for the current year.But much of the apparent strength in Q4 was aberrant, led by a surge in car registrations brought forward owing to car tax changes. Regardless, there are even some signs that the housing market slump may have eased if not stopped altogether but where anomalous weather of late may have played a part.Notably, given the signs so far this year, GDP growth seems to have reversed where we believe policy tightening and the damage to spending power from high inflation will still cause a modest recession, Even so, the better-than-expected Q4 base means we have revised up our 2023 GDP projection into positive territory to 0.6% (up from zero in December), but still kept only a modest growth rate into and through 2024, projections that now chime with the upgrade made by the Norges Bank this month. This outlook is still consistent with a marked negative output gap emerging by mid-2023 and which may extend to of over 0.5% of GDP in 2024.

Indeed, the economy may already be contracting and that may persist into mid-2023.At this juncture, we think it may not be an excessively deep or protracted recession, with a cumulative drop of less than one ppt.Moreover, we still see a form of recovery emerging in H2 and continuing into 2024, but at a more grudging pace to begin with and picking up to nothing more than moderate pace.As suggested above, perhaps most telling is this regard is the fragile consumer backdrop and outlook. Indeed, consumer confidence remains near a record-low, something that reflects a likely drop in real disposable incomes of over 2% this year. In turn, this suggests a drop in consumer spending this year of around 1.5%, this in spite of a likely drop in savings.But the main weakness will be an even bigger drop in housing investment. This may also explain how and why business surveys are now showing activity moving sideways at best. Admittedly, inflation risks may have peaked and this may have both policy and spending power repercussions that should support real activity to some degree.However, CPI inflation this year may be little higher than previously envisaged, but where a drop towards the 2% target is still expected through 2024. In addition, Ukraine-related geopolitical tensions continue, but where oil and gas prices have dropped of late but not to a degree that maintain substantial revenue from oil and gas production, something that is likely to pull the current account surplus back down towards 20% of GDP this year and remain there in the foreseeable future.

Figure 5: Credit Standards Tightening, Partly due to Cost of Funds

Source: Norges Bank Lending Survey; Factors affecting credit standards for non−financial enterprises

As for the Norges Bank, a further 25 bp rate was delivered by the Board this month, taking the policy rate to a 15-year high of 3.0% and encompassing a 300 bp cumulative hike in the last 15 months.Notably, a further hike of 25 bp has been pointed to for the next meeting on May 4 and then another such an increase later in the summer, meaning that the new policy path envisages some added 50 bp of rate hike and where anticipated easing is deferred and reduced. This outlook reflects a more positive GDP growth outlook by the Norges Bank and resultant more of a persistent inflation overshoot.We think this growth picture is optimistic in light of what has not only been a marked rise in official rates already but (as in some other DM economies), where there have been clear signs for some months that financial conditions have tightened as banks have not only raised credit standards but the rising cost of funds has become an ever clearer causal factor (Figure 5).Against this backdrop, we adhere to our existing view that the Norges Bank policy rate has peaked and will start to fall next year.