November 4, 2022

News in Charts: The euro area – delaying the inevitable

by Fathom Consulting.

Euro area GDP expanded by 0.2% in the third quarter, confounding Fathom’s expectations that the currency bloc was already in recession. Strong household consumption in Germany helped to boost activity, but with 11.7% inflation in October, this appears to be an unsustainable source of growth. Indeed, momentum has clearly eased across the bloc, from a 0.7% quarterly average in the first half of the year. Fathom’s view that the euro area was in recession may have discounted the strength in services spending, including tourism, following two years of heavy restrictions. It’s also possible that an historically higher savings rate will offer euro area households a greater degree of resilience than we expect to price shocks. Of course, with data revisions typically procyclical, it’s always possible the Q3 data will at some point be revised to show a contraction.

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News on inflation wasn’t as positive, with October’s flash release showing that prices in the euro area increased at a 10.7% annual rate in October. The ECB expects compensation per employee to increase by 4% in 2022, implying a more than 6% decline in real wages – a steeper fall in spending power than we see in either the UK or US. That squeeze is exacerbated by a lower level of excess savings from the pandemic than in the UK or US. A historically high savings rate more generally suggests that euro area households could smooth consumption if they desired. However, they have shown little appetite to accept lower savings rates previously.

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Timelier business surveys bolster the case for a euro area downturn. The ‘flash’ euro area composite PMI was 47.1 in October, marking the fourth straight month below 50, the level that separates contraction from expansion. Fathom’s own Economic Sentiment Indicators, that weigh together a slew of business and household surveys, are falling sharply, in line with previous downturns such as the GFC and euro area debt crisis, albeit higher than the COVID trough. So despite a surprisingly resilient Q3, we continue to see a euro area recession as close to inevitable in the coming quarters, as falling real wages, slumping business confidence and rising interest rates all weigh on activity.

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This bleak outlook for economic activity may explain why some on the ECB wish to ‘pivot’. The Governing Council voted to hike rates by 75 basis points last week for the second month in a row. However, it also adjusted language in the accompanying statement, in an apparent desire to push back against market pricing of future hikes. Fathom has previously argued that markets were too bullish on future ECB rate hikes, given little sign of excess demand and a particularly weak outlook for economic activity. However, core inflation has consistently surprised to the upside over the past twelve months, and that raises the question whether a modest hiking cycle will be enough to lead to meaningful disinflation, even with slumping output. Answering that question will be critical to policy, both on the continent and beyond. Policymakers at central banks in Australia, Canada and the UK have all mooted pivots towards less aggressive hiking in recent weeks.

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In contrast to some other developed market central banks, the Federal Reserve has shown itself willing to move policy into meaningfully restrictive territory. In nominal terms, the current hiking cycle is the second steepest since the 1970s. This contrasts significantly with the Bank of England, which is moving at a historically slow pace despite 10.1% inflation. While the BoE’s 75 basis point hike this week was the largest since 1989, it also signalled that fewer additional rate hikes are expected than currently priced by markets.

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Divergent policy has led to decoupling, and interest rate differentials could widen further in the near term. US two-year real rates, implied by market pricing, have increased by over 400 basis points over the past twelve months and are trading at 1.5%. This contrasts with equivalent measures for the euro area and UK, which imply persistently negative real rates of interest over the next couple of years.

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As expected, the FOMC hiked rates by a further 75 basis points on Wednesday, taking the target range to 3.75-4%. Indeed, with a recession probable in the coming quarters, the outlook for future moves will become increasingly balanced. The focus is now on the level of the terminal rate, and the FOMC continued to signal that it anticipates “ongoing increases in the target range”. Nevertheless, we judge there to be a good chance of rate cuts by the end of next year, which, on the surface, would offer a more constructive backdrop for risk assets, helping to explain their recent bounce higher. Whether that trend can continue will depend in large part on earnings, and the ability of companies to weather the expected downturn. Expect the macroeconomic outlook to become an increasing focus of interest.

The views expressed in this article are the views of the author, not necessarily those of Refinitiv Lipper or LSEG.

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