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Stagflation looms

Exogenous shocks continue to pose the biggest risk to Eurozone economic outlook and its intensity has risen since second half of the year. Significant cuts in Russian gas supply to the continent, soaring inflation and adverse impact on purchasing power are likely to be the areas in focus. A sobering Eurozone outlook also coincides with a dour view on China’s growth expectations as well as a rising likelihood that high inflation and a hawkish Fed might slow the US economy next year.

While data has softened, the extent of correction is not dire as yet. Confidence surveys have captured the fall in sentiments, with manufacturing firms’ confidence on selling prices also softening which is likely in anticipation of a slowdown in demand. Previously resilient business surveys have also given way, as reflected in the fall in the IFO’s business expectation survey.

Retail sales – value and volume terms – have moderated, alongside PMIs slipping below the neutral 50 level, impacted by a rise in input prices and uncertain demand outlook. Amongst the core-4, impact will be most pronounced in Germany due to the fallout on manufacturing activity and high dependence on Russian supplies, whilst tourism-dependent Spain and Italy (tapping alternative gas suppliers) might have some cushion. Meanwhile, credit to the private sector rose strongly in July, whilst that to households slowed.

Labour markets are yet to react to the uncertainty. Aggregate unemployment rate for the euro area fell at a record low of 6.6% in Jul22, with the concurrent rise in vacancy rates signalling a tight job market.

There are little signs of a wage price spiral taking hold, but compensation is on the rise. Negotiated wages are up 2.7%yoy in 1H22 vs average 1.5% last year. Labour unions are reportedly demanding an increase in pay, leading to a rise in minimum wages.

According to the ECB[1], through the pandemic in 2020 and 2021, when many wage agreements provided for only low or even no pay increases, wages and salaries per employee received support from the governments’ job retention schemes. Minimum wages grew average 2.2% in 2020 and 1.7% in 2021. As of Mar22, minimum wages were expected to increase in 12 of 19 euro area countries this year, laying the ground for a sharp increase this year and next, just as inflation proves to be sticky.

Energy troubles brew

A tough geopolitical backdrop is the biggest risk facing the euro area. Last year, Russian gas accounted for more than two-third of the OECD Europe supply[2]. The gas crisis has intensified since 3Q22, as Russia’s supply through the Nord Stream pipeline was initially cut to 40%, with the flow thinning further to 20% on return from a maintenance shutdown, before drawing a full stop in Aug22.

Earlier, Russia put this fall in supply on ‘technical issues’ and ‘missing spare parts’ due to the sanctions but has since ceased supplies until sanctions are lifted. As a result, gas prices in Europe are close to 10x of past ten-year averages. This stoppage has introduced a fair amount of uncertainty for Europe, particularly Germany, even as supply from other routes via Ukraine and Turkey is still reaching the continent. High energy demand during the heatwave last month and weak supplies had compounded concerns over Berlin’s ability to meet the required gas reserve thresholds, ahead of winter. Energy importers are seeing their terms of trade metrics (on higher import prices) dive.

Encouragingly, more than 80% of the EU gas storage is filled by early-Sep22[3], with Germany aiming to surpass 90% before Nov22. As gas storage sites continue to be filled up, member countries are also tapping oil or coal as alternatives, besides stepping up LNG imports. Search for alternative modes of supply and suppliers have reportedly driven costs up to over EUR 50bn, ten times of the historical average[4]. While gas reserves are sufficient for the time being, severity of the winter season and power usage will dictate consumption.

Separately, G7 countries are also debating an oil price cap, but its effectiveness is unclear and take-up rate, uncertain. This option is being considered to tap the dominance of the Western-owned and operated global oil tanker capacity as well as insurance. However, risks are that a) Russia might retaliate by cutting its oil exports, driving oil prices higher; b) convincing Asian buyers of Russian oil, e.g., India and China might be a challenge; c) buyers could see alternative invoicing methods to circumvent discounted supplies, amongst others. Nonetheless, Europe and its allies will be keen to take some retaliatory action on Moscow to pressures its finances and export earnings. 

In the meanwhile, emergency intervention in the energy markets in the euro area has become essential in light of the sharp increase in gas prices and ripple effects on businesses and households. Potential steps include: i) rationalisation in electricity demand during peak times, binding or otherwise; ii) imposition of windfall taxes on energy companies to fund relief measures for the populace, with few member countries having already set the ball rolling on this front; iii) import price cap in gas purchases from Russia, though there has been no consensus on this front for now.

Also, the EU is banning purchase of Russian oil imports from Dec 5, 2022, mainly covering cargo covered by ships but via pipelines (as a compromise for landlocked states).

Outlook

Inflation has been rising, which together with the 12% YTD depreciation in the EUR vs $, could drive headline CPI to a double-digit increase in early 4Q22 and despite the fall in petrol prices due to a correction in global prices. National governments have also undertaken direct intervention to cap energy bills, which will help effectively rein in incremental price pressures. Core readings, however, continue to rise. Our inflation forecast for 2022 stands 7.8%yoy, before easing to 5.0% next year. Upside risks to our forecast stems from the likelihood that energy prices might spike further, pulling up costs for households and businesses for remaining part of this year and into 2023.

Resilience in 2Q22 growth, base effects and revisions to past data necessitate a mechanical revision in 2022 numbers to 2.5%yoy (even as we assume growth grinds to a halt in 4Q). We assign a 40% probability to the risk that the bloc slips into recession in late-2022-early 1Q23 before returning to black. Fallout of the gas crisis and related uncertainty, besides base effects, might be more apparent in 1H 2023 and we temper full-year growth to 1.0% from 1.8% earlier.

Fiscal and sovereign debt position face two-way forces. While governments are in the process of stepping up fiscal support, economies with more room will, admittedly, play a bigger hand than the already highly indebted member countries. Expenditure has risen but high nominal GDP growth, better faring revenues and likelihood of additional revenue sources (by way of windfall taxes on energy companies that don’t use gas to generate power, new levies etc.) might offset the full extent of pain on the government’s books. That said, next year’s mix is likely to be a bigger challenge if geopolitical tensions fail to subside in the course of the year. We expect the fiscal deficits this year and next to stay below -5% of GDP.

Aggregate debt levels remain elevated, especially in Italy and (to a lesser extent) Spain amongst the core-4 countries. We expect the overall aggregate debt levels to hover in 94-96% of GDP.

Policy implications

The ECB delivered a large 75bp rate hike in Sep22, taking the main refinance rate to 1.25% and deposit facility rate to 0.75%, marking the single largest hike on record for the bloc. The two-tier system was suspended, and multiplier set to zero. Policy guidance was hawkish as inflation risks were seen as becoming broad-based, and the ECB saw the need to hike interest rates ‘several times’ in the coming months. This was balanced by remarks that a) hikes were being frontloaded; b) risks of a growth slowdown; and c) forward guidance stuck to a ‘meeting to meeting’ approach.

Data projections backed the cautious view on inflation, with 2022’s seen at 8.1% YoY (vs 6.8% earlier), 2023 at 5.5% (vs 3.5%), easing towards the target in 2024 at 2.3% (vs 2.1%). While base effects were behind the counter intuitive move of an upward revision in 2022 growth numbers, 2023 was taken sharply lower to 0.9% (vs 2.1%), with stagnation expected to set in 1Q23, just as high energy prices exert an additional tax on purchasing power. As hawks take the drivers’ seat, this rate hike cycle is likely to settle at the higher end of the 1.5-2.0% range (with upside risks of 50-100bp), rather that 1.0-1.5% we assumed earlier. With the inflation target at 2%, the terminal rate will still be far below restrictive levels.

Impending slowdown in the Eurozone growth in late-2022 and early-2023 will, therefore, be more on account of geopolitics and impending energy crisis rather than the tightening cycle. On markets, the jumbo rate hike provided brief support to the euro, which was offset by subsequent hawkish talk by the US Fed. German bond yields ticked up, as did Italian rates on the central bank’s hawkish rhetoric, with the TPI tool (Transmission Protection Instrument) positioned as a deterrent to sharp rises in borrowing costs of member countries. 

Euro/dollar pair fell to parity this year for the first time since 2002, driven largely by diverging growth and policy direction between Europe and the US. In an inflationary environment, a weaker currency had added to the imported price pressures. While euro has lost considerable ground (11%ytd) vs the dollar (bilateral exchange rate), on trade-weighted terms, the extent of correction has been smaller, questioning the purported benefits to trade competitiveness.

[1] ECB
[2] EIA
[3] Gas Infrastructure Europe and EU Council
[4] Press report

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