Global Monthly - Winter is coming

Full Global Monthly (including regional updates)

Global View: A perfect storm is gathering over Europe

The summer holidays have been anything but quiet this year. Since our last Global Monthly at the end of June, the European energy crisis has intensified, as fears over shortages of natural gas conspired with an extended heatwave to push gas and electricity prices to new record highs. Russia did turn the Nord Stream gas tap back on after the pipeline’s scheduled annual maintenance ended on 21 July, but at a reduced level. It has since threatened a further complete shutdown at the end of August, ostensibly for maintenance purposes. This has raised the risk of outright energy shortages over the winter period, with potentially crippling consequences for European industry. We said in our June Monthly that a gas shortage would trigger deep recessions in the eurozone and UK economies, and this has now become our base case. Even if Europe manages to avoid physical shortages of energy over the winter – for instance, if we are lucky enough to have a mild winter – the extreme prices for energy, weak business and consumer confidence, and tighter financial conditions are by themselves likely enough to push Europe into recession. Completing the not-so-pretty global macro picture, we expect a mild recession in the US on the back of high inflation and aggressive Fed rate hikes, while China’s post-lockdown rebound is constrained by the continuation of its zero-covid policy, as well as turbulence in the real estate sector. The one bright spot is that, aside from energy, supply bottlenecks have continued to ease – providing some relief to global inflationary pressures.

Filling gas inventories has come at a painful cost

European gas inventories are on track to meet the EU target of being filled to 80% by November – but at exorbitant cost: the price of gas has soared further over the summer, with the Dutch TTF 1 month ahead contract rising to over €300/Mwh – around 10x previous historic peaks. Inventories have been filled largely with the help of extra supplies of LNG, which have so far offset the shortfall from Russia. With constrained global supplies of LNG, this has meant energy shortfalls in less wealthy parts of the world unable to compete with the prices Europeans have been prepared to pay. We expect these high prices to push inflation even higher over the coming months, and even with relatively full inventories, the IEA estimates European countries could still face shortages to the extent that some rationing over the winter is necessary. Even in a positive scenario, Europe will still be heavily reliant on additional gas (mainly LNG) flows in the winter months, for which global competition could intensify further – potentially leading to even higher prices than we see today.

With baseload electricity supply in Europe also heavily dependent on natural gas (in the Netherlands, 60% of electricity is generated from gas), electricity prices have continued to surge in tandem. The sultry summer weather hasn’t helped: aside from raising demand for electricity for air conditioning, higher temperatures in water sources used to cool reactors in France have led to nuclear outages, while low levels in the river Rhine in Germany have delayed coal shipments – hampering plans to raise coal-fired power generation to offset likely shortfalls in gas. The gradual increase in renewables capacity has done little to help – solar energy generation has naturally broken records in the sunny weather, but wind generation has been lower than normal.

European recession looks baked in the cake – even if energy rationing is avoided

Whether Europe (the eurozone and UK) faces physical shortages of energy over the winter months remains highly uncertain, given that it is subject to many moving parts. Aside from the unpredictable actions of Russia, the degree to which industry is able to adapt and become more energy efficient is a crucial factor, as is the household response to higher energy prices and government campaigns to reduce energy use. The IEA estimates that in the absence of a significant demand response by industry and households, even with gas storage levels at 90%, European industry would face disruptions (potentially involving a rationing of energy) by February if Russian gas flows were to stop completely from October onwards. Then there are the whims of the weather to consider – the severity of the winter could by itself mean the difference between energy rationing or not.

We think there are enough factors in play to induce a recession starting already in Q3. First, there is the price shock. Even if industry does not face a physical shortage of gas or electricity over the winter, the astronomical prices being faced can by themselves make some energy intensive businesses unviable, and there have been numerous examples of this over the past year: one of Europe’s largest zinc smelters in the Netherlands will completely halt production in September due to high energy prices. Aside from the direct production loss impact on GDP of such closures, there is also the knock-on effect through the supply chains if reduced production cannot be easily sourced from outside Europe – and even if it can, likely at a (potentially much) higher cost.

Then, there is the inflation shock to real incomes. We have raised inflation forecasts further on the continued rise in energy prices, with eurozone inflation now expected to average 8.3% this year and 4.4% next year. High inflation is already hitting consumption of goods – as indicated by falling retail sales in recent months – and it is likely to increasingly weigh on the services recovery. This is consistent with plummeting consumer confidence, which is now already lower than during the first lockdowns of the pandemic in April 2020. Confidence in the labour market has so far prevented a severe downturn in consumption, but this has now started to turn, and we expect rising unemployment later this year to become an additional drag on consumption.

A further factor driving our recession call is the dramatic deterioration in business confidence, as signalled by the PMIs and other confidence indicators. In particular, PMIs suggest a significant softening in demand, with businesses citing cost of living pressures as the cause, leading to rising unsold goods and reduced activity in some parts of the services sector. Against this backdrop, financial conditions have continued to tighten. The ECB’s most recent Bank Lending Standards survey pointed to both reduced demand for loans as well as tighter lending standards, with eurozone banks adopting stricter criteria in their assessment of both household and business loan applications. Lenders cited both increased economic uncertainty and less accommodative monetary policy as the main drivers. With the ECB and BoE unlikely to relent in their inflation fighting rate hike cycles in the near term, there is little prospect of any easing in financial conditions driving an improvement in growth prospects. On the fiscal side, government support is to some extent acting as a stabiliser to activity and preventing a more severe downturn, but it is unable to fully offset it, with inflationary pressures and higher interest rates restraining political appetite to aggressively support growth.

All told, the combination of weaker demand, weaker confidence, and tighter financial conditions suggests investment is likely to decline alongside consumption over the coming quarters. We therefore expect a recession in both the eurozone and UK economies over the coming quarters, with GDP declines in 2023 of 0.9% in the eurozone and 0.8% in the UK.

US also likely to go into a recession, albeit a much milder one

We have also downgraded our growth outlook for the US economy, following the negative Q2 GDP reading and given much weaker prospects for an investment rebound. The looming recession in Europe by itself has a relatively limited impact on the US outlook, given that the US’s dependence on exports generally is low, and given that to some extent US exports will actually benefit from Europe’s energy crisis in the form of higher LNG exports. If anything, the main channel through which Europe’s energy crisis might impact the US is by further lifting inflation, due to the upward pressure higher LNG demand is putting on domestic gas prices. While nowhere near the stratospheric highs seen in Europe, US natural gas prices are still some 2-3x typical peak prices seen prior to the pandemic.

Like Europe, the main driver of the expected weakening in the US economy is the inflation hit to real incomes – which is less severe than that seen in Europe, given that nominal wage growth is higher – as well as much tighter monetary policy from the Fed. We had already expected broadly stagnant consumption over the coming quarters on the back of these factors, and we now expect this to be accompanied by a much shallower recovery in investment. While the US might narrowly avoid two consecutive GDP contractions, we expect the weak growth environment to drive a darkening in labour market prospects, with the unemployment rate expected to rise by around 1.5pp to close to 5% by the end of 2023. This is likely to meet the NBER’s official definition of a recession by the second half of next year. However, the expected US recession is unlikely to be as severe as what we expect to see in Europe. All told, we expect GDP growth of 1% in 2023, slowing from a marked down expectation of 1.7% growth in 2022.

Headwinds to China’s post-lockdown rebound do have a silver lining

In contrast to advanced economies, China’s economy is likely to continue to rebound over the coming quarters from the strict lockdowns seen earlier this year, although the pace of that rebound is being constrained by a continuation of the government’s zero-covid policy and – more recently – turbulence in the real estate market. In more normal times (think back to 2017-18), worries over potentially weaker growth in China would clearly weigh in our assessment of the eurozone outlook in particular, given its dependence on exports to China. However, in the current environment dominated by energy supply risks and massive declines in real incomes, the impact of potentially weaker export growth to China is comparatively small. If anything, worries over weaker demand in China are providing some relief to elevated global commodity prices, acting as a welcome counter to sky-high gas prices.

Is there anything to be happy about? At least supply bottlenecks are easing

If there is one reason to be happy about how the global economy is evolving at present, it is that – gas supply crunch aside – supply bottlenecks generally are easing significantly. This is clearly evident in our global supply bottlenecks index, which has plummeted over the past couple of months, driven by a much improved supply-demand balance for goods as indicated by the global PMIs, as well as continued falls in global shipping freight tariffs. Recessions in advanced economies are likely to drive a further improvement in the supply-demand imbalances we have seen, which should ultimately feed through to lower inflation – at least from the goods side of things. For services inflation, the expected weakening in the labour market is likely to play a more important role, and this will be the focus of central banks as they monitor the impact of interest rate rises in restraining activity. (Bill Diviney, Aline Schuiling, Hans van Cleef, Jan-Paul van de Kerke, Arjen van Dijkhuizen, Aggie van Huisseling)