Cooling inflation and lacklustre economic growth in 2024 will prompt the European Central Bank (ECB) policymakers to eventually pivot this year, reversing its fastest-ever monetary fighting cycle to a more supportive stance. Last year, households’ pandemic savings and high EU and member state fiscal spending offset the impact of tighter monetary policy. However, these countervailing forces are expected to expire in 2024, as pandemic savings run off and the re-introduction of EU fiscal rules supports highly indebted countries reduce their debt levels and reduce fiscal spending, paring back support for households and corporates. These effects, coupled with the delayed impact of accumulative elevated interest rates, is expected to lead to sluggish economic growth across most European markets while unemployment is expected to rise only modestly. For many, the base case is that economic headwinds associated with Russia’s invasion of Ukraine will further soften in 2024, as Western Europe reduce Russian energy reliance and diversify supply chains. However, a potential US recession would hurt domestic and external demand in the eurozone, says Fitch Ratings.
Rate cuts are the talk of the markets
The ECB held interest rates for the third consecutive time on 25 January at 4%, the highest borrowing costs in the bloc since the euro’s launch 25 years ago, and signalled the time to start easing monetary policy would come in the summer. However, president Christine Lagarde continues to emphasise the data dependent approach which shows risks to economic growth, underlying inflation and wage growth are all skewed to the downside, spurring bets that a first interest rate cut could come as soon as April.
Annual inflation in the euro area nudged back up to 2.9% in December, according to Eurostat, after falling six consecutive months to reach within a whisker of the ECB’s target in November at 2.4%, down from 10.1% a year earlier. December’s reversal is considered a minor blip attributed to declining government subsidies on gas, electricity and food, which will be reversed in January’s data, supported by continuing declines in energy and food prices.
In early 2023, European Commission forecast annual inflation for last year would fall to 5.6%. Thus, the inflation descent was a considerable forecast beat. Few predicted that inflation would plunge so dramatically without central banks creating a recession in the process. The goldilocks outturn emerged despite a raft of material risks events, including the forced sale of Credit Suisse to UBS, ongoing weakness in the Chinese economy, and a resurgent conflict in the Middle East.
Over the coming months, if headline eurozone inflation normalises in the sub 3% range and inflation gravitates back to the 2% target, the utility of elevated interest rates would fade, particularly in the context of anaemic economic activity, low liquidity in lending markets, and rising corporate balance sheet strain and defaults. Goldman Sachs analysts considers this scenario as an insurance policy against a recession. On the flip side, the longer the ECB maintains current interest rates, the higher the probability of a eurozone recession, a balancing act the ECB is highly cognisant of. Tight monetary policy will weigh on bank lending and keep eurozone economic activity weak for as long as restrictive policy is maintained.
Once rate cuts start in the euro area, economists expect the ECB to keep lowering its deposit rate until 2.25%, according to a poll of economists by the Financial Times. In 2024, the range expectation is between 75 and 150 basis points cumulatively. In such a scenario, falling government bond yields from historical highs would help to lower the cost of borrowing and ease lending standards. However, banks may adopt a “wait-and-see” mode on any easing of lending conditions until evidence of demand improvements are more concrete. The timing of the ECB’s pivot will be a crucial determinant for the severity of the bloc’s economic activity this year.
The ECB forecasts real GDP growth of 0.8% in 2024, up from a preliminary estimate of 0.6% in 2023. The base case muted recovery scenario reflects broad expectations that the euro bloc’s global competitiveness has deteriorated, while fiscal stimulus is set to fade this year. The eurozone’s final PMI survey support this outlook. The eurozone composite PMI was 47.6 in December, extending the sustained but moderate decline in business activity across the bloc to seven consecutive months. Manufacturing and services industries both saw output decrease. According to the S&P Global HCOB Eurozone Composite PMI, the largest euro area economies were the biggest drags on business activity, with France, Germany and Italy occupying the bottom three rankings in that order. Ireland and Spain saw output rise, although Spain’s expansion was marginal. The gloomy macro-outlook underscores long-standing structural issues that need resolving, including heavy regulatory burdens, and misaligned incentives and cooperation between industries, innovators and regulators. Such issues “conspire to undermine the effectiveness of the EU single market,” wrote RBC Wealth Management.
Unexpired risks and sector headwinds
Markets need to navigate a packed global elections calendar, unexpired geopolitical events, and to absorb the remaining drag on activity from tighter monetary and fiscal policy as well as lending conditions. Central bank monetary tightening slows demand by reducing credit and increasing unemployment. While credit availability has slowed, the scale is far from that of a credit crunch, while both unemployment trends and fear of unemployment have remained sanguine. More broadly, elevated levels of corporate debt, high interest rates, and a market liquidity contraction has increased borrower stress and credit risk on existing lending and has restricted lender appetite to meet refinancing requirements. A sustained high interest rate environment throughout the first half may produce lagged corporate default risk for more challenged sectors, notably construction and manufacturing.
In the residential sector, higher borrowing costs and the cost-of-living squeeze deterred many Europeans from buying a house, depressing mortgage demand, which lowered house prices while pushing up rental costs. In Q3, house prices fell by 2.1% in the euro area, as measured by the House Price Index, as reported by Eurostat. The largest falls were recorded in Luxembourg (-13.6%), Germany (-10.2%), and Finland (-7.0%). The impact in commercial real estate has been more acute, where valuations have fell precipitously in markets such as Germany, where construction has suffered from a rise in building materials and labour costs, causing projects to be scrapped and even developer insolvencies.
Several EU governments, including Italy, France, and Spain, have seen their debt levels surpass 100% of GDP. However, confidence is high that the risks of a sovereign debt or financial crisis remain low. Recent EU debt and deficit rules that aim to enforce member states’ spending prudence and address concerns over debt serviceability. Consequently, a potential shift towards austerity measures in the year ahead is considered a key risk to the eurozone economy. The impact of potential fiscal austerity measures on domestic demand will be closely scrutinised by investors and economists.
Geopolitics to test supply chain and margin resilience
The geopolitical landscape remains fractured. In addition to the ongoing war in Ukraine, the fallout from the Israel-Hamas conflict has worsened with US and UK launched military strikes in Yemen in response to Houthi rebel attacks on shipping in the Red Sea, raising fears of an escalation of conflict in the region. At an economic level, a broadening conflict will generate an inflationary impulse through supply chain disruptions to important international shipping routes. Automakers Tesla and Volvo Car said they were suspending some production in Europe due to a shortage of components, the first clear sign that attacks on shipping in the Red Sea are hitting manufacturers in the region. “The armed conflicts in the Red Sea and the associated shifts in transport routes between Europe and Asia via the Cape of Good Hope are affecting production in Grünheide,” AP reported Tesla stating. “The significantly longer transport times create a gap in the supply chains.” Tesla’s factory near Berlin was scheduled to pause from Jan. 29 to Feb. 11. Container shipping rates spiked as concerns grew that vessels transporting products ranging from clothes, phones and car batteries will have to avoid the Suez Canal, the fastest route between Asia and Europe, for longer than expected, Reuters reported.
Elsewhere, there is also the prospect of renewed tensions between China and Taiwan following the governing Democratic Progressive Party’s (DPP) third consecutive presidential election victory in early January. Elsewhere, the outturn of several elections in 2024 may well define the outlook for the eurozone, and global, economy. Most consequential is the US presidential election in November, with Donald Trump increasingly likely to win the Republican nomination again. Many of the geopolitical uncertainties will likely remain in a ‘holding pattern’ until the outcome of the US presidential election, suggests Fitch.
In the next instalment New Year outlook, we will focus on the German and Italian markets, providing macro context and the outlook for NPL activity.