Western Europe Outlook: Consumer Fragilities Persist

Our Forecasts

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

Risks to Our Views

Source: Continuum Economics

Despite the drop in energy prices (which means that the threat of immediate recession has been reduced), it is notable that this has had little impact in reviving what are still weak and fragile consumer sentiment surveys (Figure 1).  Very much this reflects the growing actual and anticipated further impact of rising interest rates, this effectively having added to, if not replaced energy as concern for beleaguered consumers.   In this regard, it is still the case that higher prices continue to damage the consumer and overall activity outlook not only via the direct impact on spending power but where repeated stubbornly high CPI readings are also undermining confidence. But the monetary policy tightening that has continued in the last few months is also clearly causing weakness in private sector credit, actually precipitating declines in the latter and in the bank deposit base in the UK and Sweden and much slower growth rates in Switzerland and Norway.  This a further manifestation of 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 the housing market (prices and transactions) 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.  Tightening is also feeding through other channels including into the corporate sector, where some weaker companies find the adjustment to higher rates difficult. As a result, near, if not actual, recession conditions are still likely in all but Switzerland despite the friendlier energy and inflation backdrop and outlook.

Figure 1: Consumer Fragility Continues

Source: Datastream, Consumer confidence indices

UK: Resilience Masks Domestic Weakness

Downside economic risks are clearly growing amid the rise in interest rates, the latter contributing to softer business survey signals. This, thereby, accentuates and/or prolongs what has been a very negative  domestic backdrop.  Unsurprisingly, these are centered around an even clearer and more protracted correction in housing, both in terms of prices, turnover and higher mortgage rates on households with this threat exacerbated by what seems to be the banking sector’s wariness to lend to households even amid greater individual stress testing of any mortgagee.  This scenario may seem to be in conflict with GDP data that has seemingly shown some degree of resilience, in which the economy has grown (admittedly barely) in the last two quarters.  But this masks disturbing details in the national account that show domestic demand having slumped almost 5% y/y in Q1, the worst performance since the GFC (excluding the pandemic period of course) and where swings in inventories account for only half this drop. There are supportive factors: not least the marked drop in wholesale energy prices which will filter through to households from Q2, but particularly in H2 and where the fiscal situation is going to be little more supportive that previously envisaged. But we are still if not increasingly 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 clearly the impact of the more sizeable tightening in monetary policy that is already causing tighter financial conditions that will bite the economy through the credit channel increasingly, this very much highlighted by unprecedented declines occurring in both the level of bank credit and bank deposits (Figure 2).  As a result, we have upgraded the GDP outlook for this year, with less chance of a formal recession given the holiday induced bounce in Q3 GDP that should follow the royal holiday generated drop this quarter.  However, we continue to envisage what will be moderate and fragile recovery later in H2 and into 2024 that still encompasses a drop in GDP of 0.1% in 2023, some 0.4 ppt less weak than envisaged back in March but where we see little of this being repaired in 2024, with our growth projection remaining at a sub-consensus 0.4%. This fragile outlook is very much led by the consumer.  In perspective, this will involve consumer spending slumping by up to 0.5% in 2023 and slipping a little further in 2024, albeit a projections also revised higher of late due to the fall in energy prices. Furthermore, there will be far less support, if not outright damage, from the housing market,

This consumer weakness will help curtail imports but the latter will recover somewhat from current depleted levels, with added gains stemming from the on-going aspiration 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 3.8% of GDP) may continue albeit more modestly, with a gap of 4%-plus still on cards by 2024.  This will be part of a double-deficit as government borrowing (likely to be over 5% of GDP in the current 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 – this being something that may unnerve ratings agencies.  But solid imports will act as a safety-valve in helping restrain domestically generated inflation, the latter having proved more stubborn than most envisaged, especially given the apparent domestic demand weakness of late.  Most likely this may reflect longer lags for prices and wage pressures to react to weaker demand.  But there are encouraging signs nonetheless, with clear signals that the labor market has loosened, most notably in terms of labor supply increasing, albeit with the jobless rate seen back over 4.5% into 2024.  The combination of the above will bring CPI inflation down clearly, now led lower by energy and this causing the revised CPI outlook where we now see a rate of 2.5% in 2024 (0.2 ppt higher than seen three months ago and lower still thereafter).  But the core rate may be take more time with discernible slowing deferred until early 2024).

Figure 2: Bank Credit and Deposit Weakness Unprecedented

Source: BoE

As for the BoE, core inflation (current and expected) is clearly the guiding force in setting policy and it has repeatedly surprised on the upside of late.  It was behind the latest higher than expected 50 bp hike this month, that being the 13th successive hike, to a fresh 15-year high of 5.0%.  Certainly the MPR has not called a peak in the hiking cycle, actually retaining a hiking bias. But we still see this hike, or at least the possible move in August, being the final move given the growing downside risks discussed above and already emanating from weakness in monetary data (Figure 2) and increasingly mounting in terms of tighter financial conditions.  That may look even more worrisome when the BoE unveils its next Financial Stability Report (July 12) and the next Credit Conditions Survey on July 13. Hence, why we adhere to rate cuts starting early in 2024, albeit from a somewhat higher terminal rate!

Sweden: Riksbank Policy Biting Broadly?

Although we have upgraded the GDP outlook, at least for this year, the risks are very much skewed to the downside as ever tighter Riksbank policy bites ever harder both through conventional means and also and surprisingly from the shrinkage in its balance sheet.  The upgrade is more mechanical than underlying, relating to the better than expected Q1 GDP positive outcome which reflected some one-off factors and a demand-induced further fall in imports.  As a result, we now see an above consensus zero GDP (up from the 0.8% drop envisaged three months ago) but where some price is paid in terms of a somewhat weaker 2024 picture, this downgraded by 0.3 ppt to a below-consensus 0.7%.  As for conventional policy, this is biting even more clearly via mortgage rates which have risen sharply over the last year and may yet 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 Riksbank interest rates have a rapid impact on households’ interest expenditure and thus on their consumption.  But there also seems to be a further avenue through which Riksbank policy may be biting, through the reduction in its balance sheet where the year-long non-reinvestment of its bond portfolio has occurred alongside (and hence possibly caused) an unprecedented drop in bank deposits, with the later now seeing a very sharp slowing in private sector credit growth as well as a marked reversal in broad money growth (Figure 3).  

As a result, the economy may now be in recession, something that chimes with what are still very sobering business surveys which we anticipate will soon lead to a softening labor market.  But the cumulative drop in GDP of less than 1 ppt weakness is nothing compared to the very fragile consumer situation, with household surveys remaining near all-time lows (Figure 1). This is  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.  We see a continued if not 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.

Indeed, the continued risk is that an inter-related cooling in the housing market (with prices ultimately dropping 10-15%) will exacerbate existing weakness in consumer spending and to a degree that means the latter may fall by well over 1% this year.  In addition, commercial real estate may be seeing even more downside risks, adding to financial stability risks that the Riksbank of which is fully aware.

There will be recovery, but it will be  modest and fragile, and which will also reflect unsurprising continued weakness in residential investment, hence the restrained overall GDP recovery through 2024 so that the latter’s growth rate may still be 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 above 5% 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!

Figure 3: Swedish Credit and Money Growth Succumbing to Deposit Drops

Source: Riksbank, % chg y/y 

As for energy costs, they are coming down but CPI data have surprised on the upside of late, this explaining the higher (7.5%) 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, the 2% target by H2-2024, this squaring with even clearer signs that core measures have stated to ease.  

As for the Riksbank, at its last meeting, and very much meeting market expectations, the Riksbank Board hiked its policy rate by 50 bp to a 15-year high of 3.5%.   This was despite still suggesting that inflation would return to target and stay there in the latter part of its 2-3 year forecast horizon, albeit this outlook conditional on an assumed further 25 bp hike in June 28-29 or September 20-21.  That hike looms at the meeting due at the end of this month but where we think the economic and financial risks alluded to above and the better inflation figures of late will lead to a policy pause being signalled, even possible explicitly.

Switzerland: Inflation Clearly Turned?  

Although the SNB will be even more of the view that Credit Suisse furor has been contained, we still think such thinking is somewhat premature as the banking sector is still showing some fragilities, most notably in terms of a stagnation in deposit growth which may have amplified the clear slowing in private credit (Figure 4). To what extent this is a reflection of SNB balance sheet reduction is unclear, instead the credit numbers falling prey to what has been a clear tightening in official interest rates and an inter-related flattening out in house prices.  Even so, Switzerland may be alone in the Western Europe section in avoiding recession, even a short  one, this very much a reflection of the limited rise in inflation and the ensuing limited policy response and where the ongoing drop in global energy prices should boost spending power.  Admittedly, CPI inflation has been be a little higher than previously expected, hence a modest upward revision but only for this year.   Indeed, we adhere to the 1.4% (and clearly back below target) outcome we have for some time envisaged for 2024.  In fact, inflation already seems to be falling and on a broad basis, with even some underlying measures back below the 2% target. However, amid continued global risks, and the likelihood that banking sector stresses and Ukraine worries may continue to weigh on what are still very gloomy consumer confidence readings (Figure 1), we are still cautious on the growth outlook, this outlook now chiming with renewed weakness in business surveys.  On balance, we largely adhere to our (March) GDP projection for 2023 of 0.6%, this broadly in line with consensus but half that of recently unrevised SNB projection.  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% and with downside risks emanating from monetary policy transmission considerations in the EZ.  

Figure 4: Swiss Inflation Falling Broadly

Source: Datastream

But the main support to growth is the modest manner in which inflation has risen through the last year. 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.

The SNB continued policy normalization this month in what seems to be a confident, but what we think is still a complacent assessment, suggesting as discussed above, it has solved the banking stresses. Indeed, the SNB met market expectations and raised its policy rates by a further 25 bp to 1.75%.  The policy rate has now been increased a cumulative 250 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 year 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 over 1.5% annualized, i.e. above Swiss trend growth. 

Norway: Financial Stability Risks to the Fore

The economy surprised on the upside in Q1, with house prices staging something of a recovery, repairing nearly all the damage seen since the previous peak set last autumn.  But monetary policy is biting, albeit the impact mitigated somewhat both by the boost to the economy from higher energy prices and (we would contend) a lack of balance sheet reduction from the Norges Bank.  Indeed, monthly GDP data have fallen in all but one month so far this year, and with survey data still gloomy, we retain out below consensus outlook for the GDP outlook, seeing a barely- revised 0.7% rise both this year and in 2024.   Adding to headwinds is an inflation rate that may be peaking (both headline and core) but has surprised further on the upside, precipitating a cumulative upward revision of 1.3 ppt that will add to the erosion of consumer spending power.  But a drop to very nearly 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 reverses 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.

All in all, we believe greater and more prolonged policy tightening (in turn triggering a fresh fall in house prices of at least 5%) and the damage to spending power from high inflation will still cause a modest recession, albeit likely to last only this and the coming quarter. This outlook is still consistent with a marked negative output gap emerging by end-2023 and which may extend to of over 0.5% of GDP in 2024.

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 around 4% 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. 

Figure 5: Financial Stability: An Array if Risks?

Source: Norges Bank 

As for the Norges Bank, and expected only by some, but twice the size of the move it flagged itself after the previous hike, the Norges Bank Board increased its policy rate by 50 bp this month. As a result, this took the policy rate to a fresh 15-year high of 3.75% encompassing a 375 bp cumulative hike in the previous 16 months. Adding to the more hawkish tone to the move was the rhetoric that pointed to a further hike in August. It was not clear what size the Board has in mind but its updated projections in the Monetary Policy Report suggest another 50 bp in hikes lies in store, but with an easing cycle still starting in Q2 next year, albeit from a higher terminal rate. Very clearly, the Norges Bank is perturbed by persistent upside inflation surprises and the weaker krone but its statement makes little of the downside surprises in activity data and with ever-clearer signs that it is reflecting existing policy tightening! Regardless the proximity of the August meeting does suggest the advertised further hike may be hard to avoid, but it may be just 25 bp but that may be the peak!