Worsening Economic Data Heads to Europe
The euro posted a rather mixed performance in Q2, ending pretty much flat against the dollar, selling off aggressively against the pound and gaining massively against the yen. From a broader macro economic standpoint, the euro zone economy spluttered as higher interest rates and tightening credit conditions constrained demand – the natural result of aggressively tightening financial conditions. Due to late revisions to prior data points, Europe’s largest economy Germany entered into a technical recession in Q1 as did the euro zone itself. Q2 led on from Q1 in much the same fashion where elevated prices constrained household incomes, reducing economic activity during a global growth slowdown – something that the ECB anticipates will alleviate in the second half of the year.
Graph 1: German GDP Reveals Technical Recession
Source: TradingEconomics, prepared by Richard Snow
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In addition, the engine room of the European economy, the German manufacturing sector, continues to fall deeper into contractionary territory, as do many of the other influential economies like France, Italy and Spain. This is significant as the manufacturing sector typically leads the services sector, which also appears to be trending lower after showing broad resilience up until recently.
Chart 1: Germany Leads Global Manufacturing Sector Deeper into Contraction
Source: TradingView, prepared by Richard Snow
ECB Communicates Need for Further Hikes, Core Inflation Could Change That
On the monetary policy front, ECB officials indicate the desire for another 25-bps hike in July, with the market anticipating the possibility of a second hike of equal magnitude in September but more likely October, taking the benchmark rate to 4%.
Table 1: Market Implied Hikes into Year End
Source: TradingView, prepared by Richard Snow
In recognition of prior monetary policy tightening, tighter credit supply and the withdrawal of fiscal support, staff projections for GDP were revised lower for 2023 and 2024 by 0.1%. However, the governing council foresees an uptick in growth for the second half of 2023 as lower energy prices and improving supply conditions are anticipated to provide greater discretionary income for individuals/households.
The major threat to staff projections is of course the reluctance of broader price pressures to come down. Great progress has been made in headline inflation but core inflation – while appearing to have peaked – remains awfully close to its highest levels since the hiking cycle began. Given the worsening fundamental data, the committee will hope to see drastic improvements in core inflation which would lessen the urgency and potentially the need for even further hikes.The committee sees headline inflation at 3% by year end but core prices are likely to be driven by a tight labour market.
Graph 2: EU headline and Core Inflation
Source: Refinitiv, prepared by Richard Snow
