Global Monthly - Where is the recession?

Global View: The easing energy crisis is a major positive, but a shallow European recession is still likely

What a difference a month makes. When we published our Global Outlook on 9 December, wholesale energy prices were more than double current levels, which already were less than half the peak seen in August. As we argue in this month’s Global View, the improved outlook for energy supply means we are unlikely to see prices return to levels seen last summer. While it will take time for lower prices to feed through to the economy, it has become increasingly clear that the shock to real incomes will now be less severe than we previously expected. As a result, we have significantly raised our GDP growth forecasts for the eurozone and UK economies. China’s reopening is also likely to be supportive for global growth, though the flipside is that this could also put a dampener on the disinflation trend of the past few months. Indeed, despite the improved outlook, advanced economies still face a significant inflation problem, which means that monetary policy is likely to remain exceptionally tight this year, even as central banks begin (as we expect) to take their feet off the brakes later in the year. Given this, the expected rise in unemployment, combined with the fact that households are still adjusting to the existing real income shock, we do still expect a European recession this year – just one that is shallower than we previously expected.

The worst of the energy crisis looks to be behind us

Since our Global Outlook publication in December, the energy crisis has continued to ease dramatically. European gas inventories, filled to almost 80% at the time of writing, are well above the average of around 60% for this time of the year, and much higher than in the same period last year (45%). Significant declines in gas demand have persisted, for a large part due to the relatively mild winter, but record new renewables capacity additions, the restart of French nuclear power plants, and continued ample LNG flows have also helped. As such, even if the winter were to turn much more severe from here on, Europe is likely to be in a much stronger starting point for the next filling season than it was last year. While it is true that Europe will likely face more intense competition from China for global LNG supplies given the country’s abrupt exit from Zero Covid, this will be offset by additional tailwinds in the broader energy space: 1) the ongoing French nuclear restart (which is not yet back at full capacity); 2) likely another record year for renewables capacity additions; 3) an expected rebound in hydro-electric output. Indeed, taking all of these factors together, Bloomberg NEF has estimated this will lead to a 28-48% reduction in European fossil fuel demand for power generation compared with 2022 consumption.

The remarkable turnaround in Europe’s energy supply outlook has naturally had a massive impact on wholesale energy markets. Gas prices have continued to plummet, and at around €60/MWh, the month ahead TTF price is now just 1/5 of the peak price of over €300 seen last August, and is trading at the lowest levels since the start of the energy crisis in September 2021. Electricity prices have naturally followed, also being now around 1/4 their August peak. While even these prices are much higher than peak prices in normal times (around €25-30/MWh for gas prices), it is a much more positive scenario than we expected even just a month ago.

Easing energy crisis means a more shallow European recession

Our new base case assumes that European energy prices will remain somewhat elevated compared to pre-crisis levels, but that we are unlikely to see the same magnitude of price spikes that we saw in 2022. This naturally implies a smaller shock to household real incomes, and therefore a shallower recession than we previously expected. We have therefore significantly upgraded our 2023 growth forecasts for both the eurozone and UK economies, and we have also lowered our headline inflation forecasts. For the eurozone, we now expect 2023 average GDP growth of -0.3% compared with our previous forecast of -0.9%, while for the UK we have upgraded our forecast to -0.7% from -1.3% previously. The pass-through of lower energy prices to households and businesses is muddied by the patchwork of price capping regimes – which vary significantly per country – and energy prices themselves are still very much a moving target, making the effects difficult to estimate with precision. However, in the Netherlands for instance, already one utility provider has begun to offer energy contracts with prices below price cap levels set by the Dutch government, and assuming wholesale energy prices remain at current or lower levels, we are likely to see this repeated in other countries over the coming months.

Industrial catch-up on easing supply bottlenecks has also supported European growth…

Aside from the receding energy crisis, the easing of supply bottlenecks has supported activity to a greater extent than we thought. Naturally, energy intensive industry has seen some production losses from the crisis, but this has been offset in particular by a rebound in car production, as global chip shortages eased. Rebounding car production has led in turn to a rebound in car registrations, reflecting the significant backlog of orders when supply was constrained. This has supported private consumption to a greater extent than we thought in Q4, and has partly offset the weakness seen in other areas of consumption stemming from the real income shock. All told, the strength in Q4 data is a major contributor to our growth 2023 forecast upgrades in the eurozone and the UK.

…but this won’t last, and so we do still expect a shallow recession

These catch-up effects are likely to fade from here on. The rebound in production has led to a significant decline in order backlogs over the past few months, while final demand in the economy has been hit by the decline in real disposable incomes. This is likely to weigh on both industrial output and consumption going forward. At the same time, the lagged impact of monetary tightening is still feeding through to the economy. We are yet to see the full impact of existing rate rises, and we now expect the ECB’s deposit rate to peak in May at 3%, meaning there is much still in the pipeline. While the recession is more shallow than we previously expected, we still also expect a rise in the unemployment rate. This, too, will have a knock-on dampening effect on consumption, as consumer precautionary saving begins to pick up again.

What impact will China’s reopening have?

China’s abrupt exit from Zero Covid is expected to cushion slowing demand in advanced economies, but we do not expect it to be a game changer. The eurozone’s dependence on China consists mostly of industrial goods exports from Germany, which is linked to growth in China’s manufacturing sector. However, even before China’s Zero Covid exit, its manufacturing sector had already reopened for a large part, and this is reflected in the easing of supply side bottlenecks over the past year. At this point, then, China’s ‘reopening’ is to a significant extent a domestic services story. Moreover, China’s recovery is still constrained by weakness in the property sector and – related to that – weak credit growth, even if these headwinds are likely to fade as the year progresses. All told, while the reopening will boost China’s GDP growth, we do not expect this to dramatically lift Europe’s (or the US’s) economic prospects. At least, not in the current environment where the weakness in real incomes and tighter monetary policy are exerting a more powerful influence on the economy. Moreover, while China will provide some extra demand impulse for the global economy, the world’s largest economy – the US – is still expected to slow significantly in 2023 (see US section). This slowdown will also to some extent offset any growth impulse from China.

Perhaps a more pronounced impact from China’s reopening could come in the form of higher global inflation – or rather, less disinflation. In the short term, this could take the form of new supply side disruptions caused for instance by increased staff sickness; this would be temporary, however, and there is only patchy evidence of disruption of this sort so far, despite the seemingly rapid spread of the virus in recent weeks. A more lasting impact could come via rising commodity prices. Prospects for stronger Chinese domestic demand has already led to a rise in base metals prices that typically fluctuate with China’s growth prospects, such as copper and iron ore. This represents a shift in the downtrend that had been in place for much of last year, although it remains to be seen if these moves will be sustained. On balance, we judge that China’s reopening will be somewhat inflationary, but coming against the backdrop of softening demand in advanced economies and the broad easing in supply bottlenecks, we think this will be insufficient to shift the broad disinflation trend.

Easing energy crisis is a boon for the economy, but challenges remain

The easing in Europe’s energy crisis is an unquestionable positive for the outlook. While there is uncertainty over the timing of the pass-through of lower energy prices to consumers, real incomes are likely to start recovering sooner than we previously thought, and this has led us to significantly raise our eurozone and UK growth forecasts. China’s reopening will also be somewhat supportive of global demand, although we must weigh this against the inflationary impact it may have.

Indeed, despite the significant falls in energy prices, the easing in supply bottlenecks and the cooling in demand, inflation continues to be the biggest challenge facing advanced economies at present. Inflation does look to have peaked; in the US it is already on a clear downtrend, and in Europe we expect inflation to trend lower in the course of the year. But there remain risks to the medium term inflation outlook – namely, the risk that higher wage inflation becomes entrenched, which could ultimately lead to inflation settling at a higher level in the medium term than central banks would like. This risk has reduced, but the easing of the energy crisis could be a double edged sword – while it is likely to lower inflation expectations and therefore reduce upward pressure on wages, the more shallow recession we expect will also mean less of a loosening in the tight labour market than we previously expected.

This highlights another, related risk to the outlook: that of a potential over-tightening by central banks. At present, central banks are understandably laser-focused on bringing inflation back to target. But in that determination, they may misjudge the risks and go too far. Implicitly in our forecasts, we expect this, as although we have further raised our forecast for ECB rate hikes – and now expect the deposit rate to peak at 3% – we also continue to expect central banks to correct course later this year once inflation risks have subsided, and to start cutting rates. For now we put our faith in central banks striking a reasonably good balance between inflation and recession risks, but there is a danger that policy stays too tight for too long, which could unnecessarily amplify or prolong the downturn.