The European economy defied expectations in 2022 but a recession is still on the cards this year. Output fell in Germany and some other industry-intensive economies in the final quarter of last year; consumer confidence (while improving) remains weak; but headline inflation surprised to the downside. Understanding the relevant force of these factors in each European economy is crucial to determining where and when recessions are first likely to materialise.
The starting point is that most European economies have now recovered their pre-pandemic levels of output. While this took far longer than for China and the US, the other major economic hubs, it is nevertheless an impressive feat when compared to previous recessions. The recovery has been fairly broad-based across the region, with only three countries — the Czech Republic, Spain and the UK — still producing less than they did at the end of 2019.
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While the first-round impacts of the pandemic may now be behind us, last year however saw European economies face a different set of headwinds — namely fiscal and monetary tightening, higher inflation, falling real incomes and the prospect of gas supply shortages. Momentum has undoubtedly slowed as a result, with GDP growth falling to zero by Q4, and some of the region’s more industry-intensive economies (e.g., Poland, Lithuania and Germany) experiencing outright contractions.
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Fathom, along with many others, had expected the euro area to contract in 2022 Q4. It did not.[1] Moreover, while core inflation remained more stubborn than policymakers would like, there were persistent downside surprises to headline inflation for the first time since 2020. What’s more, consumer confidence rose after its trough in September for all bar one of the countries shown in the chart below. That said, household sentiment remains weak by historic standards, with the Nordic countries particularly pessimistic about the economic situation.
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Swedish households appear to be the most downbeat overall, with confidence four standard deviations below normal. Sweden is also suffering one of the most severe house price corrections in the region. While the two are likely to be closely linked, it is unclear conceptually whether lower house prices erode confidence by reducing households’ assets, or if instead lower confidence weighs on housing demand and house prices. Empirically, we can say that lower confidence tends to lead to lower house prices in Sweden, but there is little sign that lower prices feed back into weaker confidence.
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UK house prices are now about 6% below their peak, but UK residential REITs have fallen by about 18%, suggesting there is more to come. The full impact of rate hikes on house prices has yet to be felt, and may not be apparent for some months as homeowners come to renew their mortgages. Results from Fathom’s global model suggest that even the rates hikes to date would be sufficient to chalk around 15% off UK house prices, without government intervention to offset this.
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The size of pandemic savings pots and how they are spent could well dictate whether countries enter recession this year. Generally, these savings pots were smaller in Europe than in North America. However, while US households have dipped into a significant portion of their savings already (we estimate as much as one third have already been spent), European consumers have generally been far more conservative, with savings remaining largely unspent in many of the region’s major economies. This cautious behaviour may mean that consumer spending remains weak, but it may also provide a cushion for households if the economic situation deteriorates.
That is not the case across the entire region, though. Excess savings are dwindling in Hungary and Poland and have been spent completely in Slovakia; in all three countries high inflation and currency risks are eroding nominal household savings faster than elsewhere. National central banks outside the euro area do have the power to prevent this, and we have seen a number of aggressive rate hikes. The further these rate hikes go, the greater the recessionary risks will become.
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For now, it seems likely that central banks will continue to hike rates until they are confident that inflation is falling back towards target. The good news is that inflation has started to surprise to the downside. The bad news is that core inflation is remaining stickier than hoped. That may mean that monetary policy will need to deliver recessions to return inflation to target.
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The views expressed in this article are the views of the author, not necessarily those of Refinitiv Lipper or LSEG.
[1] It should however be noted that revisions to GDP data tend to be negative when an economy is slowing — as the region currently is. For more, see Recession Watch: identifying recessions with uncertain data
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