Key views on Global Monthly - What if policymakers get the energy crisis wrong?
The energy crisis in Europe has intensified, and we expect deep recessions in the eurozone and UK economies. Consumption growth is being weighed by the biggest fall in real incomes in decades, while industry is being hampered by sky-high energy prices and worries over potential shortages as we move into the winter months. Governments are now stepping in more aggressively to help households and businesses, but high inflation means that central banks may need to tighten monetary policy even further to offset this. Upside inflation risks mean the Fed and ECB are in any case likely to continue raising rates rapidly at coming meetings. Europe will also continue to feel the global spill-over effects of much tighter US monetary policy, pushing bond yields higher, equity markets lower, and weighing on growth.
Macro
Eurozone – The economy is expected to move into recession in the coming quarters. We have pencilled in a modest contraction in GDP in Q3 and two more significant contractions in 2022Q4 and 2023Q1. Our annual average growth forecast drops to 2.7% in 2022 (down from 2.9% previously) and to around -1% in 2023 (down from +1.3% previously). Domestic demand will be hit by ongoing very high (energy) inflation and tightening financial conditions, which will also reduce job growth and fixed investment. Exports will suffer from slower world trade growth.
Netherlands – High growth in the second quarter of 2022 is maintained in the second statistical calculation. Regardless, we still expect a significant growth slowdown towards the end of 2022 and beginning of 2023. Consumers will face a reduction in purchasing power, in part because every month as fixed price contracts expire, more and more households are confronted with higher energy prices. The policy measures announced on ‘Prinsjesdag’ will soften the blow to consumers but cannot prevent a small downturn.
UK – Unease over the new government’s budget plans has driven a dramatic selloff in UK assets. The Bank of England will be forced to hike rates aggressively over the coming months – potentially to well beyond our new base case of 4%. While growth will be helped in the near-term by a freeze in household energy bills, this could be more than offset by potentially much tighter monetary policy than we currently have in our base case. This would have deeply damaging effects on the economy, as households in the UK are highly exposed to rising interest rates.
US – The overheated US economy is gradually cooling off. Demand is softening and supply side bottlenecks continue to ease. With that said, the cooling in the economy has not been disorderly, and the labour market remains exceptionally tight. We expect underlying demand cool further into 2023, as the decline in real incomes and interest rate rises begin to bite. Soft demand is likely to push the unemployment rate higher, with the NBER likely to declare a recession next year. Risks to inflation continue to be to the upside, pipeline pressures are easing.
China – August data brought some positive signals, with retail sales re-accelerating. Still, the data also showed that headwinds from Covid-19 policy and real estate remain firm, with property sales and investment still very weak. We think the rebound from the lockdown slump in March/April will bring above qoq growth in 2H-22, particularly in Q3, with the stepping up of support gradually filtering through. That said, the drags from Covid-19/real estate and the slowdown in global demand will make this post-lockdown rebound a much less spectacular one than that of 2020.
Central Banks & Markets
ECB – Following the 75bp rate hike at the September meeting, we expect another 75bp rate hike in October, followed by a final 50bp hike in December. This will take the deposit rate to 2%, where we expect it to peak. We have not pencilled in any rate hikes after that as the economy is expected to move into recession. This should do much of the heavy lifting in terms of fighting inflation. The risks to our forecast for ECB policy are skewed to more rate hikes in the 3-6 month horizon, given that the ECB's focus is on inflation rather than growth.
Fed – Given persistently elevated inflation in the US, and upside risks to the outlook, we expect the Fed to hike rates a further 75bp in November, and 50bp in December, with the upper bound of the fed funds rate to peak at 4.5%. Subsequently, we expect the Fed to pause, assuming inflation is moving back towards its 2% target, with modest rate cuts expected in H2 23. Near-term risks are to the upside, both in the rate hike pace and in the peak rate. The Fed continues to unwind its balance sheet at a $95bn monthly pace.
Bank of England – The growing risk of a wage-price spiral in the UK led the MPC to hike rates by 50bp at the September meeting. We now expect a further 75bp hike in November, with Bank Rate to peak at 4% by year end. Turbulent market conditions mean that there is a significant risk the Bank has to tighten policy much more aggressively, both to stem currency weakness and to offset fiscal stimulus recently announced by the government. Current market pricing suggests rates could peak as high as 6%, which would likely cause a severe recession.
Bond yields – Despite the recent jumps in bond yields, we still think the peak is in sight for both Treasury and German bunds. Thereafter, we expect weaker economic indicators to put downward pressures on yield with the 10y Bund yield falling to 1.55% and the 10y UST to 3.4% in Q4 2022. However, as short-term rate expectations continue to rise, we expect a stronger inversion of the Treasury curve and the Bund curve to bear-flatten before steepening again in H1 2023 once the market starts to price out multiple rate hikes in the course of next year.
FX – An energy crisis and a recession in the eurozone combined with a more aggressive path of rate hikes in the US compared to the eurozone will probably keep the euro under pressure versus the US dollar this year. The recent wave of risk aversion pushed EUR/USD below parity due to safe haven demand for the dollar. When financial markets calm down somewhat again, lower safe haven demand for the dollar could result in a recovery of EUR/USD. Our forecasts for EUR/USD for end 2022 stands at 1.0.