Macro - Europe

Europe struggles to get out of first gear

12 June 2023

By Henk Potts, London UK, Market Strategist EMEA

Please note: All data referenced in this article is sourced from Bloomberg unless otherwise stated, and is accurate at the time of publishing.

Key Points

  • Mission accomplished. Europe seems to have avoided a prolonged recession this year, even if growth remains anaemic
  • But, policymakers have had to do some heavy lifting with interest rates to tackle runaway inflation rates. And, more appears to be in the pipeline with this dragon far from slain yet
  • Encouragingly, consumer confidence is bouncing from rock bottom and unemployment rates are at record lows. That said, despite the surge seen in wages of late, living costs continue to be squeezed
  • In the search for fresh long-term opportunities for jobs and profits, Europe’s authorities have proposed a Green Deal initiative. The measures aim to charge up the continent’s renewable-energy growth engines, in the face of tough competition from the US and China

Fears that the eurozone economy would enter recession early in the year, dragged lower by energy-security risks, weakening domestic demand and slowing industrial output, appear to have been overblown.

Despite the deteriorating backdrop, the European Central Bank (ECB) has been forced to lift interest rates in an effort to combat record levels of inflation.

Energy risks cool

With 40% of the European Union’s gas coming from Russia in 20211, the area was always going to be vulnerable to the ramifications of Russia’s invasion of Ukraine.  Fortunately, Europe went into winter with increased levels of reserves and weather temperatures were significantly milder than expected, lowering peak demand.

European officials have managed supply-side shortages well. They have substituted some of the lost Russian gas through the aggressive importation of liquefied natural gas (LNG) and boosted power generation from renewable energy sources. 

Higher energy bills have also encouraged businesses and households to consume less. Indeed, European gas storage facilities are still more than 60% full, 20 percentage points higher than the 5-year average at this time of year2.

The easing supply and demand dynamic has been reflected in energy prices. European natural gas futures have recently been trading below €36 a megawatt hour3, having halved since that start of the year.

Whilst positive, the continent cannot afford to be complacent. Ongoing supply constraints, unusually cold seasons and recovering demand, could see prices soar again. For now, however, the risk of insufficient energy reserves undermining the economy has dramatically reduced.

Domestic demand

Unsurprisingly, household consumption has been extremely weak this year in the face of rising borrowing costs and stubbornly high inflation. The initial boost from reopening demand last year has faded and consumer spending has shrivelled to below pre-pandemic levels. Indeed, eurozone retail sales slumped 3.8% in March, compared to a year earlier4

Although real incomes remain under pressure, the economic outlook is bolstered by a resilient labour market, moderating inflation and rising wages. The eurozone unemployment rate fell to a record low of 6.5% in April, compared to a peak of more than 12% in 20135.

The tight labour market has driven up annual wage growth, which surged by a record 5.7% in the final quarter of last year6. This, however, has still not been enough to offset the increase in the cost of living over the same period.

Consumer confidence has slowly recovered, albeit from a very low base. The eurozone consumer confidence index rose to -17.5 in April from -19.1 in March, hitting its highest level in more than a year7. Despite some hopeful signs, household consumption will likely remain constrained over the next couple of years and weigh on growth prospects.

Industrial production remains weak

Despite stronger demand, improving supply chains and lower energy prices, industrial production continues to lag the recovery in the service sector. In March, euro area industrial production contracted by 4.1%8 and the S&P Global Eurozone Manufacturing PMI fell to 45.8 in April9.

While current output levels are robust, as manufacturers rush to fulfil a backlog of orders, the volume of new orders is disappointing and has declined for eleven consecutive months. In anticipation of more economic weakness, producers have cut inventory levels and employment in the sector grew at its slowest pace in more than two years.

Geographically speaking, southern European manufacturers have been outperforming their northern counterparts, with Greece and Spain topping the league table. Meanwhile, German activity has softened and industrial action has hit French output.

On a positive note, input costs fell for the first time since the pandemic. This should eventually filter through to lower prices and ultimately help stimulate demand, albeit taking some time to come to fruition.

Green Deal promotes switch to renewable energy

The European Commission (EC) published its legislative proposals for the Green Deal Industrial Plan (GDIP) in February10. This new framework aims to speed up the EU’s green transition and create a more competitive environment for the region’s net-zero industry. Financing will come from a third of the €1.8 trillion set aside for the Next Generation EU Recovery Plan and the EU’s seven-year budget11.

Under these proposals, the EC wants to change the EU’s climate, energy, transport and taxation policies to help reduce net greenhouse gas emissions by at least 55% by 2030, compared to the levels in the 1990s11.

The green strategy is based around four major pillars. First, create a more predictable and simplified regulatory environment. Second, accelerate the funding of investments in clean-tech industries, while preserving the integrity of the single market. Third, establish a skilled workforce to support the green transition. Fourth, expand free-trade agreements to promote green transition at a global level and export good environmental practises, while defending the single market from unfair trade practices.

Assuming that these proposals are formally adopted by the European Parliament and the Council, the GDIP could radically alter Europe’s development of clean technology and renewable energies. If implemented effectively, and efficiently, the plans would add high skilled jobs and promote innovation in the sector.

Eurozone inflation sticks to the high side

Eurozone inflation has been stubbornly sticky this year. The harmonised index of consumer prices (HICP) ticked up to 7% y/y in April12. At the same time, core inflation eased to 5.6%12 from a record-high of 5.7% in March, helped by slowing goods price momentum.

Headline price pressures are still likely to moderate through the year, driven by slowing food inflation, falling energy prices and helpful base effects. As such, the HICP is forecast to average 2.8% by the final quarter of the year, decelerating to 2% at the end of 2024.

Policymakers will be keeping an eye on wage negotiations as an indication of coming inflationary pressures. A winter of strikes around Europe and aggressive pay demands from public sector workers are likely to keep wage inflation hot for an extended period.

In Germany, for example, 2.5 million public sector workers will get an average annual 5% wage rise for two years, plus a one-off payment amounting to €3,00013. In France, private pay is also accelerating, with hourly wages from private payrolls rising to 5.2% in Q1.

ECB battles the inflation dragon

As expected, the European Central Bank (ECB) hiked rates by 25 basis points at its May meeting, taking the deposit rate to 3.25%14. It was the smallest increase of this cycle, but unlike the US Federal Reserve, the ECB cannot declare a ceasefire in its battle with inflation.

Whilst the monetary policy statement didn’t provide any specific forward guidance on the path of policy, it indicated that the Governing Council will remain data-dependent and take decisions on a meeting-by-meeting basis.

Interest rates will probably need to be lifted again later in the year. Policymakers appear determined to take action that is sufficiently restrictive to win the battle against inflation.

Life in the slow lane

Further quarter-point hikes in policy rates appear likely at the June and July meetings. This would take the deposit rate to 3.75% and probably represent the top of this hiking cycle. That said, the central bank may keep rates on hold until the second half of next year, probably followed by a percentage-point of cuts in in the next six months.

Despite some dire predictions around the length and depth of the contraction in Europe, the region is likely to avoid a prolonged recession this year. This, however, should not mask the significant challenges the continent faces. It still has to deal with energy concerns, lacklustre household consumption and a stalling manufacturing recovery. Elevated interest rates, and inflation, will hit economic prospects for some time, which might act as a drag until well into next year.

Consequently, at best, European growth will be anaemic, being forecast to chalk up a 0.5% expansion this year, and 0.4% in 2024.

Europe economic forecasts, year on year (%, F=forecast)

Source: Barclays Investment Bank, Barclays Private Bank, June 2023


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