Inflation and the tightening of financing conditions have led everyone to expect some degree of recession this year. The US is expected to slow down because a large savings buffer and a vibrant job market make the US consumer able to withstand more expensive goods and services. This is an enviable position compared to the recession anticipated in Europe.
The consensus is for two consecutive quarters of negative growth in the winter of 2022-23 and a -0.1% growth for the year as a whole. Our team has been even more bearish since the start of the war in Ukraine, pricing in a full 1% decline in gross domestic product this year as the phase out of cheap energy imports from Russia and constraints to the quick diversification of supply meant energy scarcity would reduce economic activity.
Rationing seemed hard to escape. It had become clear by mid-December that governments were going to succeed in achieving maximum energy storage but this would not have been sufficient to cover all the energy demand, even in normal winter temperatures, because storage capacities are physically limited. They vary across countries, covering less than a month of normal winter consumption in Spain and Portugal and an average of only two months in Europe overall. Also, generous fiscal spending to alleviate the rising cost of energy, not always targeted only to the lower income segments, did not encourage the reduction of energy demand.
An unusual combination of luck and fear produced the needed fall in energy demand and has limited the pain. First, winter temperatures are 8 degrees Celsius above their 30-year historical average. Second, the rollout of public awareness campaigns about energy scarcity was successful. The message of ‘I reduce, I switch off, I delay’ in the French media and the EcoWatt phone app to alert of coming energy emergencies sent a popular signal about the importance of energy discipline. Fear of blackouts in the dark of winter turned out more effective than higher prices to stimulate energy efficiencies. In most-exposed Germany, households cut gas consumption by 26% and the industry 34%.
We are now embracing a more optimistic European outlook. Economic activity will most likely not contract during the whole year. There may be enough energy left under any weather scenario to avoid energy rationing this winter. Storage levels will also be higher at the end of winter, making it easier to refill for next winter. We have revised our 2023 outlook from a 1% contraction in economic activity to something closer to economic stagnation.
As prices continue to adjust to more expensive energy, the European Central Bank will keep tightening policy. More expensive energy sources in a globally limited supply environment mean that the general price level has to reset higher during the course of this year. Consumer prices need to cover the higher cost of such an essential input as energy. This transition may take the whole of this year, accounting for China’s steady state energy demand as it reopens from lockdowns, before inflation stabilises at a low level again in 2024.
The ECB will keep frontloading rate hikes to channel inflation expectations and wage demands down, along the declining path of actual inflation. Recession expectations account for a lot of policy tightening this year, with 150 basis points of rate hikes. This reflects the ECB’s strong credibility when it says it wants to bring inflation back to target. It will be helped, however, by a strong downward push from the high base of the price level starting in March last year, reflecting the sudden rise in energy prices after Russia invaded Ukraine. It is likely that the ECB will need to hike at least 25bp less than priced in.
When the facts change, markets reprice. Stagnation – even a small slowdown – is a different ballgame to a recession. Markets could not count on luck and fear to nudge Europe in the right direction in the face of this large energy shock. The EuroStoxx 600 index has de-rated by 6 points from its 18.5 price-earnings ratio at the end of 2020. The euro has depreciated by more than 20% versus the dollar. Earnings should prove resilient as firms have shown efficiency in energy use and the depressed euro is a meaningful tailwind for an exporting powerhouse. Cheapness matters when fundamentals prove better than priced in. This year, Europe has room to surprise to the upside of a downbeat consensus.
The bond market also has room to rally. With Federal Reserve hikes in the US likely to be underestimated and ECB tightening exaggerated, euro area fixed income may outperform the US. Normalising energy prices reduce the risk of an overshoot in budget deficits as the cost of government support to the energy bill of households and firms fall. Further support may also be avoided. Lower-than-expected sovereign issuance needs in a year when the ECB withdraws its asset purchases reduce the pressure on yields and support bond prices. It also reduces fragmentation risks, allowing the ECB to proceed with the gradual quantitative tightening policy it announced last month without major hiccups.
The risks to this outlook may not be those currently expected. With signs that Russia is ready to negotiate, the start of the peace would be a good piece of news that is not priced in anywhere. The top risk comes from the US, where consumer demand seems inflation-proof. Without any policy rate hike priced in for the year as a whole, a Fed that needs to tighten will spread contractionary financial conditions globally, handicapping recoveries elsewhere.
Agnès Belaisch is Chief European Strategist, Barings Investment Institute.