Eurozone economy grows but it's not all sunshine and rainbows
The Eurozone economy grew in the final quarter of 2022, even though domestic demand contracted. While the near-term prospects for the economy have improved a little, the outlook is far from bright and medium-term challenges remain considerable.
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GDP Growth Slows to 0.1% QOQ
The eurozone economy slowed but growth remained positive in Q4 2022. GDP grew by 0.1% QOQ, performing better than the -0.1% consensus expectation and the -0.3% we had pencilled in. Among the five largest member states, Spain posted the best result with growth of 0.2% QOQ, although the headline figure masks a sharp contraction in domestic demand and a drop in imports being the ‘driver of growth.’ Germany’s performance was weakest, as its economy shrank 0.2% QOQ.
Figure 1: Quite some dispersion in GDP figures; headline figures mask weak domestic demand
Based on the (limited) available data provided by member states, eurozone investments seem to have held up better than we had expected, while private consumption contracted more than projected. Investment developments differ widely between member states though. Furthermore, net trade seems to have made a positive contribution, because imports contracted more than exports – so it supported GDP, but not exactly for the right reason. Some caution regarding the expenditure components is warranted here, however, due to limited data availability at this point. From a sectoral point of view, it seems that the manufacturing sector outperformed expectations, helped by fading supply chain disruptions and a post-pandemic backlog of work. In any case, stronger activity in many non-energy-intensive sectors has more than offset the reduction in energy-intensive production over the course of 2022 (see Figure 2). Energy-intensive industries account for a bit over 20% of total EU industry.
Looking ahead, the recent fall in energy prices, the reopening of China, and renewed/increased government support underpin the short-term economic outlook for the eurozone. The recent fall in wholesale energy prices, gas in particular, lowers the inflation outlook, and together with well-filled gas storages, it also greatly reduces the short-term risk of forced output cuts or rationing. Hence the outlook for production in energy-intensive sectors has improved. Still, we caution against too much optimism given that prices are still historically high and some producers have already shut down or scaled back permanently.
Figure 2: Energy-intensive sectors have reduced output, but this has been offset by other sectors
Figure 3: Positive surprises and better risk appetite among investors
Meanwhile, the strong labor market will also continue to support private spending and the recent positive energy surprise has also provided impetus for improved market sentiment (such as a rise in equity prices, as shown in Figure 3). This better near-term outlook is also reflected in a modest rebound in business and consumer surveys (see Figure 4).
Yet recent better-than-expected data does not mean all is well. The eurozone continues to face some big picture headwinds. Most importantly, interest rate hikes will be working their way through the economy for quarters to come, while energy costs and inflation continue to be relatively high. Meanwhile, household savings adjusted for inflation have come down from their pandemic highs in most member states, suggesting that households’ capacity to absorb shocks with savings has declined, though not disappeared. Furthermore, government measures may well provide support the short run, but they come with risks attached. Euro area member state experience shows that measures to cap prices can fuel gas consumption, while in fact the EU needs more savings to be out of the woods. Moreover, these measures may push the bill for the energy crisis further down the road -and possibly increase it, if measures are not targeted. Finally, the external environment has indeed improved with the reopening of China, but we still expect the US to enter a recession in the second half of this year.
In the next section we take a closer look at the impact of the recent positive energy surprise and the progress reducing gas consumption. We then turn to a broader assessment of recession risk, where we single out the (higher) interest rate environment as one of the key risks ahead.
Figure 4: Business and consumer survey results have improved in recent months
Figure 5: Household saving may soon turn into ‘dissaving’ (dropping below 2019 levels)
Big Positive Energy Surprise
Just a few months ago Europe was still expected to experience a difficult winter with freezing temperatures, potential gas shortages and forced rationing, widespread industrial shutdowns, and a severe economic downturn. But the weather gods decided otherwise. A few more weeks of above-average temperatures and the 2023 filling season from April to September may be a breeze. This is also reflected in a further collapse in both front-end but even longer-dated forwards for the European TTF gas price benchmark. The last time we saw a price of around EUR 60/MWh for the 1M forward was September 2021. And the three-year forward is trading around EUR 38/MWh. While that is still a bit higher than before the Russian invasion of Ukraine, it is nonetheless more than 75% below the peak levels recorded last August. While low liquidity in such longer-dated forwards implies that they have a tendency to follow or correlate with the more liquid front end of the curve, the ‘signal’ that these recent data provide is definitely more than just short-term, weather-related optimism. Our energy strategist now expects gas prices to move in a corridor of around EUR 58 to EUR 90/MWh in the coming months.
Riding the ‘Transitory After All’ Inflation Wave
At the very least, these forecasts imply that headline inflation numbers should come down further in the months ahead. Producer price inflation has already slowed significantly in recent months. And the positive HICP surprise in December, with headline numbers falling from 10.1% to 9.2% YOY, 0.3 percentage points below consensus, basically confirmed that the worst of the (headline) inflation wave is now behind us. We recently reduced our near-term forecasts for headline inflation to an annual average of around 4.6% for 2023, down from the previous 5.9% (see Figure 7). However, we should also bear in mind that several member states have introduced dynamic mechanisms to cap gas and electricity prices for households and businesses. Even when wholesale prices drop sharply, this is not necessarily transmitted directly to end users. Moreover, swathes of households that had longer-term fixed prices are only just now being confronted with higher energy bills.
Figure 6: Are lower gas prices showing the way for producer and consumer price inflation?
Figure 7: Headline inflation to drop more sharply in months ahead
The sharper fall in headline inflation will also lead to downward ‘pass-through’ effects to core inflation. Yet in a previous article, Why Is Inflation Diverging in the Eurozone?, we noted that it will take at least a few more months before the pass-through of past energy price hikes is complete. As a result, the downward trajectory for core inflation is likely to be quite shallow. With recent wage agreements also showing more upward pressure on wages and labor costs, such stickiness is likely to be sustained well into next year. As such, the recent upside surprises in core inflation in a number of member states is not surprising.
So, while markets are now riding the downward leg of the inflation wave (some may even argue that this shows that it was ‘transitory’ after all), it is mostly the short-term outlook that has improved. Risks (and uncertainty) further out continue to be quite high.
Gas Saving Still Has Some Way To Go
As gas storages remain well-filled, Europe gains time to build more gas storage capacity and negotiate contracts with new suppliers. For sure, a cold snap could still push up front-end prices (hence the partial reversal that is still assumed in our gas price projections), but the ability to cope with near-term shocks has improved.
Overall euro area gas consumption in the second half of 2022 (up till November), unadjusted for weather and/or Covid-19 effects, was around 14% lower than in the same period of 2021. This probably reflects quick wins through energy-saving measures by households and output cuts in gas-intensive industries. In a more thorough analysis, where we adjust for temperature and economic activity effects, we conclude that gas consumption for the whole of 2022 was probably around 11% lower compared to what it should have been. However, in the months of September to November, which offered better opportunities to turn down the thermostat, for example, those savings were significantly higher (at an average of around -21.5% compared to the expected level of consumption, as shown in Figure 8). This is definitely a positive development.
Interestingly and importantly, though, the reduction in gas demand was significantly stronger in member states that have allowed end-user prices (proxied by the HICP gas price index in Figure 9) to rise more sharply than in those countries that limited the price impact through mechanisms such as price caps. Malta, which basically fixed energy prices for households, serves as a prime example. The country even consumed more gas in the last six months than in the same period the year before!
In view of recent initiatives by member states to shield or compensate energy users, this is also an important lesson for the year ahead. The reduction of gas use needs to be significantly more than what has been achieved so far in order to really take Europe ‘out of the woods.’
 We regressed Eurozone gas consumption – from January 2008 to December 2021 – on 11 seasonal dummies, the index of industrial output and retail sales, and a European temperature measure. We also added one AR(1) term. The residuals of that regression are well-behaved and the overall R2 of the regression is 0.972, with a Durbin-Watson-statistic of 2.41 which does not point at residual autoregression. We then projected forward gas consumption based on these variables for the remainder of 2022 and calculated the difference between actual and estimated gas consumption to obtain the monthly and cumulative gas saving since January 2022.
Figure 8: Considerable eurozone gas saving – even when adjusted for activity and temperatures
Figure 9: Gas saving: incentives at ‘work’ (June-November 2022 compared to previous six month period)
Short-term Outlook Better, but Caution Warranted
RaboResearch was among the first institutions back in early 2022 to forecast a eurozone recession, which we expected to unfold by the end of 2022/early 2023. At the time, that call was largely based on the huge energy price shock. Given the eurozone’s reliance on external energy sources, the corresponding huge terms of trade shock – even when compared to historical episodes of commodity price volatility – was the key trigger for higher inflation and slower growth ahead.
The positive energy surprise of late along with several other developments mentioned above highlight the possibility that economic activity may not slow down as sharply in the coming quarters as we had expected. It also raises the question of whether the economic contraction has been avoided altogether, with an increasing number of market participants acknowledging just that. At the same time, they admit that if a recession materializes after all, the impact could still be significant and the market less prepared.
One way to approach the question of a recession – both from a short- and medium-term perspective – is the statistical (and eclectic) recession-probability framework we developed in the years before the Covid-19 pandemic. For the past couple years our recession-probability models were basically ‘unusable’ due to the particular nature of the Covid shock (obviously economic activity fell very sharply and abruptly in 2020 but then recovered remarkably sharply as well). But we believe now is a good moment to take stock once again. In the next section we provide a summary view of that approach.
A Mixed Picture That Supports Near-term Optimism, but Medium-term Caution
As a refresher, our recession-probability framework is based on an historical analysis of a selected set of indicators. In a nutshell: For each indicator, we perform a linear regression of a recession dummy (1 for recession, 0 otherwise) on that particular input. Given the discretionary nature of a recession, we use a probit transformation of the input data. Secondly, we use a polynomial distributed lag of the input variable, which allows us to infer the amount of lead time for each indicator. Some indicators are to be considered coincident recession forecasters, while others have longer-leading properties. The output of the model then gives us a probability estimate of recession at a particular point in time. The distributed lag structure also allows us to plot a forecast of that probability for the months ahead. By doing so for a broad dataset we construct a heatmap of recession probabilities (see Figure 10).
The top level of this heatmap consists of ‘coincident’ or even ‘lagging’ recession indicators, such as consumer spending, industrial output, and unemployment. Except for retail sales volumes, which were quite weak already, most of these indicators are not pointing to any elevated recession risk in the near term. Car sales are actually giving the opposite signal, but we may need to take this indicator with a grain of salt due to earlier supply chain disruptions.
The next section contains consumer and business sentiment as well as the OECD leading indicator. These have some ‘leading’ properties and the OECD composite leading indicator (CLI) points to a high recession risk, notably from Q2 2023 onward. The commodity price indicators are increasingly pointing to recession risk over the course of 2023. As a reminder, the commodity price shock was the key reason for making our end of 2022/early 2023 recession call back in March 2022. So even with the recent fall in wholesale energy prices, this risk hasn’t entirely receded.
Finally, financial indicators are still painting a mixed picture. The flattening and inverting yield curve is increasingly pointing to recession risk, but it has not always proved a reliable indicator in the past. On the other hand, real money supply (M1) – which has proved not only the most reliable indicator (together with the OECD CLI) over the entire estimation period (1965-2019) but also the one with the biggest lead time – is flagging a >99% recession risk by April 2023.
Figure 10: Recession heatmap, 2006-2023
An overall, weighted, point estimate of the current probability of recession is now around 50% and is projected to reach 55% to 60% in the coming months (see Figure 11). However, we should add that, due to cross-correlation between the various components, such a weighted estimate has never reached levels higher than 80%, not even in 2008.
Therefore, we still believe ‘recession’ remains the best description of the medium-term outlook for eurozone activity.
Figure 11: Overall recession probability
The brief summary above also indicates that there is still a good deal of uncertainty, which is also reflected in a comparison of the current state of our heatmap with previous recession episodes. First of all, the current pattern is less conclusive than during the 2008-2009 and 2011-2012 episodes. The standard deviation of the individual indicator readings is about 30% compared to an average of around 15% over the entire sample. Secondly, there is a marked distinction between indicators with no or short lead time (low risk) and those with a relatively long lead time (elevated risk). The average weighted probability of a recession currently stands at 47% and rises toward 56% by mid-2023 after which it stabilizes. In other words, our recession heatmap actually fits quite well the narrative that while the risk of a near-term recession has fallen, the outlook continues to be weak.
Since the interest rate environment is clearly part of that medium-term recession risk, we zoom in on this particular issue in the next section.
Financial Conditions Could Be Key for 2023-2024
Orthodox economic theory prescribes that rising interest rates should ultimately produce slower growth and decreasing inflation, but expects it will take time for these effects to be fully realized. The length of time between rate hikes and the eventual outcome is uncertain. This is why economist Milton Friedman coined the infamous term “long and variable lags.” That is not just a convenient shorthand, but effectively an admission that an economy is complex and that it is difficult to assess and predict accurately the impact of rising rates on macroeconomic outcomes.
Simulations with our own NiGEM model suggest that a 100bp rate hike will ‘cost’ about 1.75 percentage points of GDP, all else equal (see Figure 12). But its full impact is only felt after more than two years. Considering that the eurozone has just experienced the sharpest rise in interest rates in more than 30 years (with the ECB’s deposit facility rate likely ending up at 3% to 3.5% this year from -0.5% in mid-2022), this obviously supports the case for caution with regard to the economic outlook.
Figure 12: Impact of a 100bp interest rate shock on eurozone GDP, all else being equal
Figure 13: The cost of borrowing is at its highest since 2014
On top of the rise in base rates (see Figure 13), we find a combination of wider credit spreads and tightening of credit standards by banks (the sharpest tightening since 2011, according to the latest Q4 2022 ECB Bank Lending Survey, as shown in Figure 14). Although sentiment in credit markets has been remarkably strong in recent months, we should stress that the bank lending channel remains significantly more important to the economy than the direct-financing channel. In fact, the sharp tightening of credit conditions suggests investments won’t fare well in the coming quarters (see Figure 15). The ECB’s reported reduction in demand for loans for investment and the recent reduction in the outstanding amount of loans on banks’ balance sheets support this (more) pessimistic view. While maturing Covid loans and support schemes are clouding the loans data, we believe investment growth is set to slow substantially.
Figure 14: Higher risk premiums; tighter credit conditions
Figure 15: Tightening of credit standards bodes ill for investment
And, when we look at monetary policy, this time things could be different, as any (mild) slowdown in activity is unlikely to lead to a quick pivot by the ECB. The persistence in (core) inflation will simply not allow that. Indeed, the ECB may even have to do more than the 100bps of hikes we have currently pencilled in. We expect the ECB to keep rates on hold for the remainder of the year once it has reached its terminal rate. In other words, short-term rates are still going up and won’t come down quickly thereafter.
As loans mature and/or companies and households face interest rate resets, the pain of the higher interest rate environment will be increasingly felt. Although member states vary considerably and businesses often use swap contracts to fix a part of their interest costs, the share of corporate loans seeing either an interest rate reset or a refinancing moment within the next 12 months are 32% and 27%, respectively.
While the gradual economic slowdown that took hold over the course of 2022 was predominantly caused by the now dissipating energy shock, higher interest rates and tighter credit conditions should either prevent a quick rebound in activity in 2023 or could still push the economy into a more protracted downturn.
As such, we believe the recent optimism about the economic outlook, while understandable because things could have been a lot worse, could well turn out to be transitory.