Eurozone GDP growth slowed in Q3, contraction ahead

In the third quarter, Eurozone GDP growth slowed to 0.2% q/q, from 0.8% q/q in the second quarter. The Eurozone’s largest economy, Germany outperformed expectations, by expanding 0.3% q/q -rather than contracting with 0.2% q/q. Not many details are given, other than that private consumption expenditure was the main driver. Italy also did quite a bit better than expected, by growing with 0.5% q/q rather than stagnating. Meanwhile, France and Spain managed to grow 0.2% q/q, broadly in line with expectations. In the three countries, growing service sector activity was the driving force, while industrial activity contracted or stagnated. Like in Germany, private consumption was also the main driver in Spain, while investment and inventory building did the trick in France, in Italy we only know that domestic demand as a whole contributed positively. In all three countries, net foreign trade contributed negatively as imports grew faster than exports. The latter attests to a deteriorating international environment (such as in China), whilst the Eurozone’s dependence on energy-intensive import products has increased and European companies have hoarded inputs and final products -a legacy of the pandemic.

The Eurozone’s third quarter GDP figure was sligthly better than the stagnation we had pencilled-in and follows a streak of positive growth surprises in 2022H1. Going forward, however, we expect the Eurozone economy to enter contractionary mode. Starting in the final quarter, we expect this contraction to last for several quarters (Figure 2) and is followed by a relatively shallow recovery starting end-2023. Of course our projections are subjected to risks. As we have experienced time and again, the Eurozone economy has become an expert in outperforming expectations. Yet, as explained in more detailed below, we remain of the view that the Eurozone cannot escape a recession. Forecasting the timing, depth and length of a recession is fraught with risks, however.

The composite Purchasing Managers’ Index has been in contractionary territory in the four months till October, with activity gradually weakening across sectors. Activity recently has clearly been the weakest in manufacturing and construction, but with the reopening boost now faded, the tourism season over and the cost of living crisis starting to really bite, activity in the services sector is also following suit. Barring pandemic lockdowns, factory and service sector output are contracting at rates not seen since the aftermath of the European debt crisis. Looking forward, new orders are weak across the board, while inventories have been building in many industries because of hoarding and disappointing demand. Backlogs have been reduced at a significant pace, suggesting output will contract more sharply in the months ahead. Although on the bright side, recent stock building should result in less inflationary pressure for consumers at some point, inflation will continue to be very elevated. Firms still report high cost pressures stemming from high energy costs and growing wage pressures, which they will likely try to pass through to customers (although a weakening demand situation could make this more difficult).

At the same time, food and energy prices are unlikely to come down substantially and structurally anytime soon. Yes, the gas price has fallen substantially recently, as stocks are filled and the very mild weather has significantly reduced seasonal demand. But as soon as the weather turns, demand will increase again and prices are likely to go up. Moreover, with close to no Russian gas flowing in anymore, Europe will need to scramble for even more alternative gas supplies when stocks are depleted after this winter and filling season starts again to prepare for the winter of 2023/ 2024, with the market being very tight. That said, base effects will start to have a dampening effect on inflation over the coming months. We currently forecast inflation to peak end this year at around 11% and to average 8.5% this year and 6.3 % next year.

High inflation and the war in Ukraine have been two of the main drivers of falling consumer confidence for over a year now (Figure 4). Since June last year consumers have been getting less optimistic about the economic outlook and their own future financial situation. Since this year consumers have turned outright pessimistic with most components of the consumer confidence survey currently at all-time lows. Importantly, households’ assessment of their current financial situation is entering negative territory as well -when compared to its long-term mean-, indicating not only are consumers expecting things to worsen, but they actually start to experience it. This clearly bodes ill for consumption going forward. A still very strong performing labor market across the block continues to help dampen the spending contraction, but labor market performance is set to weaken. In fact, employment growth has already been slowing and wage growth, while accelerating, cannot keep up with inflation. In time, we expect vacancies to be withdrawn and some job destruction. Although the current tightness and expected government policy -specifically short-time wage schemes- are likely to put a lid on unemployment growth.

One final important development that is working its way through the economy is rising interest rates. Tightening ECB policy -with another 75bp rate hike announced yesterday- has already led to a substantial increase in government bond yields and tightened credit standards and conditions on bank loans to households and businesses. This will put a lid on both housing and business investment. The latter is also underscored by the fact that according to the latest bank lending survey of the ECB, firms applied relatively more for credit to build working capital rather than for investment. This tightening of financial conditions could both deepen as well as lengthen the current slowdown.

While above developments are somewhat predictable, there are also factors that are less so. For example, the weather can have a substantial impact on energy prices, as shown recently. Hence, long bouts of unusual warm or cold weather could alleviate or worsen price pressures. Furthermore, we don’t expect a financial or debt crisis, but recent volatility in interest rate and foreign exchange markets is a reminder that such a scenario cannot be entirely dismissed. Finally, we expect government support measures to provide some relief, but do not expect wonders. In fact broad-based non-targeted support measures being implemented in multiple countries could actually lengthen and possibly aggravate the problems we are facing -especially high inflation and less gas. Looking at our forecast, in the short term, risks regarding government policy are probably on the upside, as governments are quickly ramping up support and we took a rather conservative approach in our projection with regard to its impact. In forthcoming publications we will dive deeper into the broad range of announced measures and their impact.

Looking beyond the short term, there are considerable risks on the horizon for the European economy. Even though gas prices are likely to fall as the United States and Qatar are increasing their LNG export capacity and Europe is increasing its import capacity, the costs for LNG are structurally higher than pipeline gas due to extra costs for liquification, transport and regassification (figure 5). Moreover, gas prices have increased much less in competitor countries like the US, giving (energy-intensive) US manufacturers a significant competitive edge over their European competitors. While this gap will come down somewhat over the coming years, we expect it to remain large for at least years to come -much larger than in the previous decades.

This will put pressure on the business model of many European companies, especially those companies that are i) energy intensive; ii) operate on low margins and/or in bulk markets; and iii) have little pricing power. This effect is already painfully visible in the basic chemicals, metal and fertilizer industry. Production in these sectors has collapsed: fertilizer production, for example, is down by 70% according to Fertilizers Europe, whilst aluminium production is down by 50%. European import of these goods has surged more than exports since energy prices started to rise in the Summer of 2021.

Without energy prices in Europe coming down significantly (and structurally), some of that production is unlikely to come back. A structural solution would be to speed up the energy transition, but that is easier said than done. The current power grid is not capable to handle such as surge in electricity demand in many countries and it may take years for the power grid to be expanded. Next to bottlenecks in the infrastructure, there is also a lack of renewable energy production capacity. Yes, there are plenty of plans for huge wind and solar parks, but these will take years to build as well. Moreover, renewable energy can still not be considered a stable source of energy due to a lack of batteries to store/ save the part generated but not used. Meanwhile, the outlook for green hydrogen to replace a vast amount of gas used by industry is still a faraway future. And, finally, the majority of European politicians are not (yet) ready to embrace nuclear, which could in fact provide a stable flow of electricity but would also take a very long time to build. All in all, while things are moving and investments in the green energy transition are being sped up, European businesses likely have to get by with alternative fossil fuels and production cuts for many years to come.

Brussels and national governments will not simply allow this to happen, but their hands are tied to some extent. Whilst they can support the green transition and businesses in the short term, long term gas subsidies are extremely expensive (and are directly at odds with the goal of reducing gas demand!). And given the fact that the Eurozone’s current account balance has recently entered negative territory (figure 6), uncovered fiscal spending can trigger a confidence crisis in government bonds and the exchange market (just ask the Brits!). Central bank support (through the purchase of government bonds) seems to be at odds with the current sentiment in Frankfurt (which is aimed towards quantitative tightening) and would wreck the euro. After all, it is nearly impossible to control both interest and exchange rates without draconian measures at the same time (just ask the Japanese!). In other words, there is no easy way out and policy makers will need to use all the levers they have at their disposal to prevent the energy crisis from turning into an economic downturn of gargantuan proportions.