RaboResearch - Economic Research

Eurozone GDP surprise masks weakening trend

Economic Update

  • The Eurozone economy grew by 0.7% q/q in 2022Q2 The German, French, Italian and Spanish economy expanded by 0%, 0.5%, 1% and 1.1% respectively
  • We still expect the eurozone economy to enter a shallow recession in 22H2-23H1, although the risks of a severe contraction due to an energy crisis have increased
  • Inflation figures continued to rise in July. Even though we expect inflation to cool a little towards the end of the year, upside risks are clearly present
  • We expect the ECB to raise the policy rate by 50bps in September and October, whilst raising it by 25bps in December. Strong Q2 growth may help the ECB defend another big step, but looking ahead, a significant slowdown of activity remains thSummae main downside risk to this call.

Eurozone GDP growth surprises

The Eurozone flash GDP figure surprised on the upside this morning. The eurozone economy grew by 0.7.% q/q in the second quarter of 2022, compared to our forecast and consensus estimate of 0.2%. Whilst the German economy stagnated, the French, Italian and Spanish economies expanded by 0.5%, 1%, and 1.1%, respectively. Breakdowns into components are not yet available for all countries, nor the Eurozone. But based on the available information domestic demand seems to have been the major driver, while net foreign demand contributed negatively.

Growth was still supported by a reopening of the services sector and a booming tourism sector, although that momentum has faded recently according PMI surveys. The question is, what will economic growth look like when we are off the post-covid highs and in the reality of an economy with high inflation, high uncertainty and non-negligible risk of energy shortages? Inflation reached a new record-high of 8.9 in July.

Figure 1: GDP growth figures for 2022
Figure 1: GDP growth figures for 2022Source: Macrobond, RaboResearch. Note: Shaded bars are Rabobank forecasts


But the outlook is weak

According to recently published economic surveys, the future looks rather bleak. Even though the eurozone economy still managed to expand in the second quarter, the signs for the coming months are flashing red. In July, the composite Purchase Managers Index dropped just below the neutral mark of 50 points for the first time since February 2021 (49.4). The decline was driven by a small contraction of activity in the manufacturing sector (49.6) and nearly stagnating activity in the services sector (Figure 2).

Figure 2: PMIs are pointing towards a moderate contraction
Figure 2: PMIs are pointing towards a moderate contractionSource: Macrobond, IHS Markit

Worryingly, manufacturing output took a nose dive into contractionary territory (46.1), accompanied with a record increase in stock building of finished goods, hinting at a larger than expected fall in demand. In addition, new orders declined in both manufacturing and services and business expectations in especially the manufacturing sector are very downbeat. On a country level, the contraction of activity was most marked in Germany, where also the services sector PMI entered negative territory.

In addition to these downbeat producer indices, consumer confidence reached a record low in July (Figure 3). While all components of the index are deteriorating, worries are specifically large with respect to expectations for the general economic situation and households’ own financial situation. Especially the latter bodes ill for consumer spending going forward.

Figure 3: Consumer confidence at records-low
Figure 3: Consumer confidence at records-lowSource: Macrobond, RaboResesearch

These sentiment figures combined with record-high inflation in July (8.9%, Figure 4) -despite governments’ effort to temper the impact of risen energy prices- and increasing interest rates, line up with our forecast of a mild recession in the Eurozone in the winter of 2022. We note that our current mild recession forecast includes higher energy prices, but no energy shortages. Since we published that forecast, the situation has clearly deteriorated more quickly than expected, with Russia squeezing more and more gas flows to Europe. For the time being, we stick to our base scenario of a mild recession. However, a worse scenario with outright gas shortages has terrifyingly high probability.

Figure 4: Inflation still on the rise
Figure 4: Inflation still on the riseSource: Macrobond, RaboResearch

If the risk of acute gas shortages is likely to materialize, we will update our forecast accordingly. This would result in a considerably larger contraction of the Eurozone economy than we currently envisage, with the German and Italian economy taking the brunt of the economic damage.

Inflation: Heating up or cooling down?

The inflation figures in July are likely to give consumers and the ECB even bigger headaches. In July, Eurozone inflation reached another record-high of 8.9%.

Going forward, the path for inflation is very dependent on what happens with Russian gas flows, and hence energy prices, but in any case it isn’t expected to come down fast.

For now, we stick to our baseline and assume that inflation will gradually start to come down in the final quarter of 2022. This is mostly due to base effects as energy prices started to rise already in late 2021. Moreover, on average, commodity prices -apart from gas- have already eased recently, while recently published PMIs also hold some good news on this front. Inflation from the supply side moderated somewhat as some supply chain issues eased. There is also less inflationary pressure from the demand side. Producers reported that stocks of finished goods rose at an unprecedented pace as sales came in weaker than expected (perhaps due to the dwindling purchasing power of consumers). Simultaneously, input stocks rose as well, as producers stockpiled goods as a response to uncertainty regarding the robustness of supply chains. The combination of rising stocks and falling demand might cool inflation somewhat.

All that being said, inflation is set to remain very high and largely above the ECB’s 2% target. Core inflation (the most sticky kind of inflation) has continued to rise, while both input and selling price increases reported in the PMI surveys remained at levels nowhere seen in the years prior to the pandemic. And it goes without saying that a complete gas crunch could push prices significantly higher.

Q2 GDP eases the ECB’s dilemma slightly

Although lowering aggregate demand is exactly how central banks fight inflation, the anticipated slowdown in activity comes at an awkward timing. Since the current bout of inflation wasn’t so much caused by overheating demand and more so by supply chain disruptions and mismatches in the economy, a slowdown or even a mild recession may not be sufficient to lower inflation meaningfully. And the ECB may therefore have to choose between cooling inflation or sustaining growth.

Markets have recently pared back their expectations for ECB hikes, expecting that concerns about the growth outlook will eventually cause the ECB to pause or stop its tightening. While we also don’t like the idea of the ECB tightening through a sharp slowdown, the Council’s tolerance for growth risks or even a modest slowdown seems to be elevated as long as inflation remains uncomfortably high. Price stability remains their primary mandate, after all. After the July meeting, President Lagarde noted that “inflation risks remain to the upside and have intensified, particularly in the short-term”.

These inflation risks are only exacerbated by the recent depreciation of the euro, whilst the introduction of the Transmission Protection Instrument (TPI), designed to contain peripheral spreads, further paves the road for more rate hikes.  We therefore expect the ECB to hike the policy rate by 50bps in September and October, whilst we expect a 25bps in December. There are two key assumptions behind this forecast. First, we expect that the TPI will be effective in limiting peripheral spreads and fragmentation risks in the Eurozone. Second, we assume that the economic outlook does not deteriorate too sharply. To that extent, the surprisingly strong growth in Q2 certainly makes it easier to defend another big hike in September than would have been the case if the economy had already shown signs of slowing. Of course, looking ahead, growth risks remain to the downside.

These risks are roughly offset by the risk that inflation will further surprise on the upside whilst the economy is still performing relatively okay. In this case we expect the ECB to further tighten monetary policy.


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