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By William H. Witherell, Ph.D.
Negative factors are piling up for the United Kingdom and the Eurozone economies in the outlook for the second half and the winter months. Global growth prospects have deteriorated. The Russia-Ukraine war drags on, dampening investor, business, and consumer attitudes. Energy markets are being hit hard, driving prices high; and gas rationing is being required in the Eurozone. Surging inflation, which is eroding consumers’ real incomes, is requiring central banks to step firmly on the monetary policy brakes despite the fact that economic momentum is already weakening. The risk of a trade battle between the UK and the EU has risen as UK ministers seem set on taking unilateral action to water down the Northern Ireland Protocol. It is certainly an unfortunate time for the UK to be without a leader, for political turmoil in Italy to be threatening the government of Mario Draghi, and for France’s President Macron to lose his absolute majority in Parliament, making it very difficult to pass needed legislation. As this commentary is written, Europe is also suffering under a severe heat wave and drought-fueled wildfires.
The openness of the United Kingdom and the Eurozone economies means their growth prospects are strongly affected by the outlook for exports, which in turn depends on global economic growth and currency developments. The International Monetary Fund (IMF) has recently announced that it is downgrading its global growth-rate projections for both 2022 and 2023. Those rates were already reduced significantly in April. The main concern cited is “commodity price shocks” caused by the Russia-Ukraine war, which has generated a “cost of living crisis” and a “further disruption in the natural gas supply to Europe.” The Bank for International Settlements (BIS), an institution of the World’s central banks, has warned that the financial system’s resilience may be tested by deteriorating economic conditions, citing volatile debt markets, volatile commodity markets, and deeper than expected scarring from the Covid pandemic. In the short term, rebounds from Covid restrictions in China, along with ramped-up policy stimulus there, are contributing to a slight improvement in global growth in the current quarter. This improvement could be cut short should China impose further Covid lockdowns. On the other hand, an extended recovery in China would provide a basis for the global economy to avoid a recession and achieve a “soft landing.” Even in this case, some economies would experience a recession, particularly heavily indebted developing and emerging-market economies but also possibly some economies in Europe.
The UK economy surprised in May with robust growth following three months of stagnation, but that reading was distorted by holiday dates. June PMI data showed a decline in manufacturing, offset by an increase in services. It still looks as though the economy will be found to have fallen slightly in the second quarter. Looking forward, a likely worsening of inflation will cause a steep fall in real incomes. Although the UK’s energy situation is not as bad as the energy crisis expected in the EU, UK gas and electricity prices have surged recently; and the energy price cap is now expected to rise by some 60% in October. The government is providing some support to offset energy bill increases; but overall, fiscal policy is tightening as the government unwinds Covid policy support. Financial markets are tightening, as the hawkish Monetary Policy Committee has raised the bank rate in five successive increases to 1.25% in June. The Conservative Party had promised a reduction in taxes, but that measure will likely have to await the election of a new leader and prime minister to replace Boris Johnson. Replacing Johnson involves a two-stage process: First, sitting MPs vote in a series of rounds until just two candidates remain. That stage has been completed with Rishi Sunak and Liz Truss the finalists. Next members of the party vote with the winner being announced in early September. While the candidates differ somewhat on tax cuts versus focusing on inflation, there appears to be agreement on tearing up the post-Brexit trade arrangements for Northern Ireland, despite the real risk of a trade war. A new prime minister may be more willing to negotiate a solution. Considering all these likely headwinds, the UK economy may register GDP growth of 3.5% this year, with growth momentum slowing in the second half. Next year, GDP growth is now projected to be less than 1%.
The Eurozone economies are experiencing the brunt of the negative effects of the Russia-Ukraine war. They are absorbing a massive flow of refugees and ramping up their military and economic support for Ukraine. Inflation is surging, expected to reach 7.6% for the year according to the latest forecasts by the EU economists. This figure is considerably higher than their spring forecast of 6.1%. The European Central Bank (ECB) is considerably behind other central banks in addressing this problem. Only later this week is it expected to hike interest rates for the first time in a decade. Credit conditions are already tightening sharply according to the just-released bank lending survey, which reported a broad-based tightening of credit standards. The ECB is planning a series of interest rate hikes. It is unclear, however, whether the hiking cycle will continue beyond year end, as economic activity looks likely to cool markedly in the winter months and inflation may well be slowing then. This will follow several more months in which EU economies continue to benefit from eased Covid-related restrictions and reductions in international supply bottlenecks.
The most serious threat to EU economies is the risk that Russia will use fuel supplies to Europe as an economic weapon. Russia has already reduced its supply of gas, and there is limited scope to offset shortfalls with supply from other sources. Rising energy prices are a main driver of inflation, along with food prices. Countries that are more dependent on Russian gas, particularly Germany, Italy, and some central European economies, could experience major shocks, with gas rationing and significant impacts on industry. Consumption is likely to slow as wage growth lags rising costs.
Political uncertainties are always present in Europe. France has one of the strongest economies, and its services sector is now benefiting from a post-lockdown surge in demand. However, President Macron is now hamstrung by a highly fragmented National Assembly. The country will need to have legislative measures to provide support for the economy or to deal with any new Covid outbreaks, should they occur. The manufacturing sector, already a weak part of the economy, faces the threat of possible gas rationing. Macron also has promised a program of structural economic reform measures. In the absence of an absolute majority, he will find that governing and passing any laws will be extremely difficult. New elections are a distinct possibility.
In Italy, the government of Prime Minister Mario Draghi is in crisis as the populist Five Star Movement, part of Draghi’s national unity government, withdrew its support in a vote on a 26-billion-euro aid package to help families deal with soaring inflation. The party has close links with Moscow and disagrees with Italy’s support of Ukraine. Despite still commanding a majority in parliament, Draghi offered his resignation, which was rejected by Italy’s president, Sergio Mattarella. Draghi now faces a vote of confidence. He has asked Italy’s Senate to agree to a new coalition. Both the Italian business community and international investors hope that Draghi, a former ECB president, will stay in office, as he has been an important stabilizing force, both in the country and in the EU. I agree. When I was at the OECD, I was fortunate to participate in a committee chaired by Draghi and was impressed with his wisdom and his negotiating skills.
The political crisis in Italy has increased the difficulties facing the ECB as it starts a cycle of rate increases. Italian bond yields rose sharply when Draghi offered to resign. The ECB wishes to avoid what it calls “fragmentation”: unjustified increases in some countries’ financing costs, leading to a divergence in yields across the Eurozone. On July 19th, the Italian-German 10-year government bond spread was 2.185%, higher than the 1.14% spread of a year ago but well below the peak of 5% during the 2012 debt crisis. A new, controversial scheme called a “transmission protection mechanism” is being proposed by the ECB to tackle fragmentation. Critics note that it will be difficult to distinguish between unjustified interest increases and justified movements in yields. Nevertheless, it looks likely that the scheme will be approved, with some constraints, as no one wants to see another debt crisis develop.
In view of the headwinds confronting the Eurozone economies, we were not surprised to see the EU economists make further cuts in their growth forecasts, which now average 2.6% for 2022 and just 1.4% for 2023. Germany, with the largest Eurozone economy, appears likely to suffer greatly during the winter months from the expected natural gas shortage and high energy costs. We project Germany’s GDP growth to be only 1.3% in 2022 and 0.9% in 2023. Germany could experience a technical recession during the winter. Italy looks likely to register a 3% economic growth rate for 2022, but it too may slow to 1.8% growth in 2023. We expect France’s economy to do better overall, with GDP growth rates of 2.7% in 2022 and 2.3% in 2023.
Projections for a cold winter, with economies barely advancing, do not bode well for Eurozone equities, as earnings are likely to contract. Valuations are already very depressed, which should limit the extent of further market downsides. The energy crisis will be less severe for the UK and its stocks, which may continue to outperform Eurozone equities. At Cumberland, we have reduced our Eurozone position while maintaining our UK position in our International Equity ETF portfolios.
Sources: Financial Times, Oxford Economics, actioneconomics.com, Goldman Sachs Economic Research
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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