UK and euro area macroeconomic outlook

Now, with a deepening energy crisis and soaring inflation – currently at a 40-year high in the UK[mfn] https://www.ft.com/content/2fb6f361-a7bb-4b98-8100-6847b5df79b4 [/mfn] – there are fears a recession is just around the corner.

Third Bridge Forum has spoken to a number of specialists in recent weeks to obtain their insights on how the current macroeconomic environment in the UK and eurozone might unfold through the remainder of 2022 and into 2023. 

Click here to view an article looking at how US consumer markets are responding to rate hikes, and the likelihood of a recession.

Recessionary outlook – UK and Europe

In this Interview, a divisional leader at Macrobond Financial AB said they believe there will be UK rate hikes of 50bps until the bank rate reaches approximately 3%, at which point a recession will be triggered. 

Our expert pointed to the BoE’s forecast that YoY GDP growth will be negative from the end of 2022 and throughout 2023 — so “potentially four or five quarters of economic stagnation and low and slightly negative growth”. 

With European inflation now over 9%, the ECB is forecasting rate rises into 2023, whereas the BoE is forecasting rate cuts in 2023. However, given eurozone “structural issues”, our expert does not anticipate that the ECB will hike rates through end-2023. “I don’t think they’ll have to hike a lot in order for inflation to come down on its own.” In their opinion, the ECB should not increase rates by more than 50 bps at a time. As for the BoE, our expert said markets are “pricing in a peak interest rate of 3% by the beginning or mid-2023”, after which point it will cut rates.  

On the eurozone’s secular stagnation and above-mentioned structural issues, our expert highlighted Italy as a country that, given its high debt ratio, “we really need to be concerned about”. The ECB’s transmission protection instrument (TPI) is aimed at preventing a scenario such as the European debt crisis of 2011-2012. However, our specialist described it as a “politically charged situation”, with German politicians “very much against these interventions”. 

The bigger issue at play, according to the expert, is that some eurozone countries have not experienced strong growth for a long time. “After the financial crisis, some of these countries lost a decade”. The long-term outlook for parts of Europe is therefore “quite gloomy”. Overall, our expert is more optimistic about the eurozone’s recessionary outlook than the UK’s, with the latter still tackling Brexit-related supply challenges and inflation that is “far too high”. 

UK household spending

In an Interview with a former HSBC executive, we heard that pandemic savings are still elevated, but households have stopped hoarding cash. However, it remains to be seen how long these savings will last, given the inflationary environment.

Similarly, we were told households have not yet decreased spending, though a larger portion of income is going towards utilities and essential products. “So this adjustment phase has not even started yet,” our expert said. Borrowing is starting to increase, and these conditions may tighten in line with higher debt repayments, according to our Interview.

If the BoE’s base rate goes beyond 5%, our expert believes UK financial stability will weaken and the banking sector will come under pressure. Real disposable incomes could fall faster than previously expected “unless we see a fiscal response”, they added. “Now, the obvious question here… is how far would rates have to go up before the Bank of England became concerned from a financial stability perspective? Sir Jon Cunliffe… gave an interesting answer because he indicated that rates would have to rise significantly.”

Sir Jon Cunliffe suggested that “significantly” meant a further 200-500 bps, which is above current market expectations of a 3% ceiling. So, “we’re looking at a bank rate of 5-8% before the Bank of England becomes concerned from a financial stability perspective”, our expert said.

Eurozone household spending

Turning to household spending and consumer credit in the eurozone, the aforementioned executive painted a similar picture to the UK, albeit less severe, in this Forum Interview. Households have also stopped hoarding cash and are borrowing again, with signals from the eurozone and UK money sectors “highly synchronised”. 

We heard the following trends are positive for the eurozone growth outlook: moderation of household deposit flows, recovery in consumer credit, and money and credit cycles resynced. However, like the UK, “rising inflation has overtaken all of those positive messages”.

According to the former HSBC executive, the biggest risk to eurozone financial stability is the shift towards less productive financial institution and real estate-based lending, accounting for half of all outstanding loans. “Not only has lending since the global financial crisis been relatively subdued in volume terms, and now it’s actually negative in real terms, it’s also largely been the wrong type of lending. This is my biggest concern in terms of financial stability for the eurozone.”

If real disposable incomes continue to fall, there could be a “complete reversal” of the pandemic trends of households saving less and/or borrowing more, we heard. Annual growth rates in narrow money, household credit and corporate credit are now “falling sharply in real terms”, which we were told is important because they each have a long-term relationship with real GDP. “Once you bring inflation into the story, the message is that you have very significant headwinds facing the growth outlook in the euro area.”

The European Central Bank in focus

We heard from a divisional head at Allianz SE that central banks are “inherently ill equipped” to deal with supply shocks, which have historically been temporary but are now more pervasive. According to our expert, “raising rates is not the antidote”, and that is the challenge that central banks are facing.

The ECB is in a particularly difficult position given the diverse nature of eurozone countries, so it is tasked with striking a balance between addressing inflationary pressures and maintaining the integrity of the eurozone. “Fighting inflation also has consequences for the refinancing needs of governments and this brings about the fragmentation risk which the ECB needs to take into consideration.”

As previously mentioned, the eurozone inflation rate is now above 9% and heading towards double digits, keeping the ECB on “high alert in the coming months”, our expert said. After the 50 bps hike in July, our specialist believes the ECB is likely “to maintain the tightening pace”, adding there is a “high probability” of further 50 bps hikes until the ECB stops at 1.75%.

“It’s quite clear that Germany is headed towards a recession, and being the eurozone’s largest economy that would also mean the eurozone is headed towards a recession.” Normalisation could see core inflation falling to about 4%, followed by a terminal bank rate of about 2% in Q1 2023. However, a deeper recession could result in the ECB stopping at 1.75% or less, our specialist said.