How concerned should we be about the European economy? - September 4, 2023
After a clear but brief recovery at the start of the year, Europe’s economic outlook is once again giving cause for concern. Activity is slowing down significantly and inflation even rose slightly in August. Are fears of a recession, or even stagflation, justified?
In her latest speech, prominent ECB Executive Board member Isabel Schnabel highlighted the possibility that the eurozone economy will experience a period of “stagflation” – that is, stagnation of activity in conjunction with persistent inflation. The business climate, as measured by business surveys, has fallen sharply again since May (Graph 1), which could translate into economic stagnation in the third quarter and beyond. With the post-COVID reopening boom in services coming to an end, which protected employment last year, the outlook for the labour market is becoming more precarious. Credit conditions have also tightened significantly and fiscal policies have become less accommodating. Finally, industrial stocks are considered to be significantly too high by the companies surveyed, which does not bode well for production.
To prevent these negative factors from leading to a recession in the eurozone, it is crucial that consumption picks up. One of the necessary conditions for this recovery is disinflation. August’s inflation figures (+0.6% over the month for consumer prices in the eurozone, following -0.1% in July) call this into question. However, the poor inflation figures for August are concentrated on energy. Excluding energy, inflation continues to fall across almost every sector, and the leading indicator of inflation constructed by the ECB teams (the Persistent and Common Component of Inflation – PCCI) suggests that annual inflation is expected to move towards 3%, compared to 5.3% today (Graph 2).
However, Isabel Schnabel expresses concern that European disinflation will be slowed down by industrial supply problems resulting from the 2022 energy shock and the low level of unemployment. That said, the pace of disinflation in the first half of the year was fast. Annualised over the last 6 months, eurozone inflation is already very close to 3%, compared to 10% last year. This disinflation has led to a rise in consumer confidence and a stabilisation of retail sales since the start of the year (Graph 3). Barring any external shocks, gains in purchasing power should therefore continue, with wages currently climbing at a pace slightly above inflation.
Overall, the debate on Europe’s growth prospects between now and the end of the year remains largely open. The risks of recession undeniably exist but the context of disinflation reduces these risks, as does the steadfast momentum of “green” corporate investment. The best way to judge this will be by means of the labour market – which must not falter – and energy prices (oil prices, natural gas prices during autumn/winter etc.).
In terms of the markets, the weakening of the European economic outlook since the spring has already been largely absorbed. Firstly, because it is less of a surprise, as indicated by the eurozone’s economic surprise indices, which are recovering slightly after their sharp drop in the second quarter. Secondly, because the valuation of European equities (as per the equal weighted index) is sitting at the very bottom of the developed markets scale, two points below the global average in terms of PER (Graph 4). Finally, the recent economic slowdown is starting to make the ECB hesitant, reducing the risk of a further surge in sovereign bond yields, at least in the coming weeks. Therefore, the risks of a significant decline in European equity markets on the sole basis of economic concerns in the eurozone seem on the moderate side at this stage.
