Capital Ideas^TM

I was recently asked how I could square my view of a more resilient European economy with leading financial indicators that point to a sharp downturn.

Last autumn, I thought we were on the verge of a significant recession across the major European economies. I expected real gross domestic product¹ (GDP) to contract in the second half of 2022 and then fall in 2023 by 1-2% in Germany, France, Italy, Spain, the Netherlands, and the UK. Energy prices were soaring, inflation was high, and the real-income squeeze was intense. Elsewhere, real bond yields (the difference between the rate of inflation and interest rates) had jumped from their lows, sentiment was weakening, and money supply² growth was dropping significantly, which is usually consistent with a significant downturn. More broadly, concerns were growing about a US recession and persistent Chinese economic weakness.

I was wrong. Europe’s economy was surprisingly resilient in the second half of 2022, primarily because domestic demand (consumption and investment) held up better than I expected (with stronger real incomes and lower saving). More recently, sentiment surveys (European Commission, Purchasing Managers' Index (PMI), German IFO Business Climate Index) have shown broad-based improvement across consumer confidence, industry, services and retail. Forward-looking indicators have seen some of the biggest improvements and this has caught almost all economists off-guard: Goldman has materially revised up its GDP forecasts and now does not see a recession in 2023 with a continuing recovery in 2024, for example.

I was too pessimistic last autumn and – so far – the economy has been much better than expected. I think there are several reasons for this, including lower energy prices, changing energy consumption behaviour, more fiscal support and pent-up demand from the pandemic. But I am struggling to calibrate what this means for the economy this year and into 2024.

I hear warnings from colleagues in fixed income about the negative signal from bond markets (higher real yields, flatter yield curves³, falling money supply). Others have highlighted the near-300 basis point jump in real yields across major markets over the last year. For instance, Germany’s real 10-year yield is now positive for the first time since early 2014; it was -2.7% last March.⁴

I am left pondering a number of questions:

- Is it the change or level of real yields that matters for economies/markets?

- How quickly will central banks pivot from their current rate hiking strategy?

- Will we see a soft landing⁵ in the US?

- How much can we expect from China’s re-opening?

- Is Europe weathering the energy shock better than anyone expected?

- Has fiscal policy become structurally looser?

- Are we seeing reflationary behaviour from the eurozone’s private sector (lower saving, more spending) as distinct from the deflationary mindset of the 2010s?

I do not have definitive answers to these, and so – for now – have done what most forecasters tend to do (some may remember JK Galbraith’s warning, ‘There are two types of economic forecaster: those who don’t know, and those who don’t know they don’t know’). I have rolled the weakness I initially expected in the second half of 2022 into the first half of this year and now believe it will be a milder contraction with a more subdued recovery in the latter half of 2023. I expect a milder recession in the eurozone (mainly in Germany), with full-year GDP down around 0.25-0.50% in 2023. The UK is likely to be weaker given its bigger inflation problem, less fiscal support, and sensitivity to higher interest rates (-1% GDP in 2023).

I am more cautious than those suggesting the eurozone will avoid recession but equally, less bearish than I was. While I understand why some of my colleagues are more bearish, I think it is extremely difficult to forecast a deep recession one or two quarters ahead. I accept there is a risk but don’t believe I can predict a broad-based collapse in confidence among consumers and companies. The latest data suggest we are not seeing anything like that, despite negative signals from money supply and the yield curve.

It might be a question of timing or that private-sector behaviour in the eurozone has changed relative to the experience of the last decade, which would raise the real interest rate required to slow the economy. Of course, the European Central Bank (ECB) could yet push interest rates up to a level that triggers such a collapse, but I believe it would probably tolerate moderately above-target inflation rather than risk a deep recession and the financial instability that might entail.

I am much more worried about the UK given its deep-seated structural problems, its fragility in the face of large shocks, and evidence that inflation expectations are de-anchoring among consumers and companies. But it is still very difficult to forecast a deep (Global Financial Crisis-style) recession as much depends on how the private sector responds to higher interest rates and lower house prices. I regard a deep recession as a risk scenario rather than my base case.

1. An inflation-adjusted measure that reflects the value of all goods and services produced by an economy in a given year.

2. Also known as real M1, this is money supply composed of currency, demand deposits and other liquid deposits, including savings deposits.

3. The yield curve is a line that plots yields (interest rates) of bonds with equal credit quality but differing maturity date. A flattening curve, where longer-dated bonds are offering similar yields to shorter, signals expectations of weaker economic activity.

4. As at 26 January 2023. Source: Bundesrepublik Deutschland – Finanzagentur GmbH).

5. A moderate economic slowdown following a period of growth.

 

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• This material is not intended to provide investment advice or be considered a personal recommendation.
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