EY European Economic Outlook – April 2023

European economy shows resilience, yet faces a bumpier recovery path

In the January edition of our economic forecast, we signalled that latest data increased the likelihood of a softer landing for the European economy. It has proven more resilient than many expected, leading to an upward revision of our GDP forecast for 2023. However, downside risks prevail, making the recovery path more challenging. Despite headline inflation declining due to falling energy prices, underlying price pressures are proving sticky, indicating that interest rates may remain higher for longer.

The European economy has been slowing since mid-2022, with inflation continuing to exceed nominal wage growth and acting as a drag on consumption. While rising interest rates have also taken their toll, economic growth surprised on the upside, with stagnant GDP in Q4 2022 and likely modest growth in Q1 2023, quelling previous expectations of an imminent recession.

Considerable budgetary support measures for households and firms helped many to weather the energy crisis, assisted by lower energy costs due to a mild winter and ample natural gas storage at European facilities. Resilient labor markets continue to support consumer income and China’s reopening has contributed to global demand recovering.

Euro area inflation passed its peak in October (10.6%) and began to decelerate, driven by falling energy prices and base effects. In coming quarters, declining inflation will bring some respite to consumers. Real wage growth, after reaching a low at -4.9% in Q3 2022, is accelerating and is expected to turn positive in Q4 2023. Despite the banking stress that hit financial markets during March 2023, recent data suggest that this has not impacted hugely on consumers and businesses. As a result, most European economies are expected to avoid GDP contraction in 2023. 

So far, so good? 

Unfortunately, the outlook is not as rosy as it may seem

Prolonged elevated energy prices and inflation, compounded by monetary policy tightening, will continue to impact household consumption and economic growth. In our baseline scenario, in which we assume that the recent financial sector turmoil is contained, GDP growth in the euro area should decrease from 3.5% in 2022 to 0.7% this year, recovering to 1.3% in 2024 and 1.9% in 2025. Growth is therefore expected to be slower than the pre-pandemic 2014-19 average of 1.9%. Overall performance of European economies will remain notably below pre-Covid trends, pointing to the long-term negative effects of the pandemic and the war in Ukraine.

The slowdown in global trade (from 5.0% in 2022 to 1.1% in 2023 and 2.5% in 2024) will weigh on Europe’s exports and manufacturing

Trade channels play a particularly important role in European economies and the recovery in the US, UK and China will be of key importance, since these represent the EU’s most important trading partners.

Manufacturing activity in Europe will also be affected by the build-up of inventories during the post-pandemic boom, particularly in Germany, Poland and France. Faced with slower demand, many companies will adjust inventories accordingly, which will amplify the adverse cyclical impact on industrial output.

There are some sectors, though, where easing supply bottlenecks allows them to realize order backlogs that outweigh, at least in the short term, the negative effects of demand slowdown. Notable examples include the aerospace and automotive sectors, which are recovering from considerably weaker performance than pre-pandemic.

Supply bottlenecks are receding quickly, which is enabling faster recovery of supply. Coupled with slowing demand and reversal of the previous shifts in consumption patterns (away from services toward goods after the pandemic), should lead to lower industrial margins. Declining commodity prices, particularly energy costs, will gradually filter through to other prices. This should support disinflation of industrial and consumer goods, which is already reflected in companies’ business outlook, especially in energy-intensive sectors. 

With a tight labor market, workers may use their bargaining power to recoup lost income

As headline inflation decelerates, we expect growth in nominal wages in the euro area to remain near current levels in 2023, resulting in real wage growth turning positive in the last quarter of this year. In CEE countries, nominal wage increases will reduce from often double-digit levels, but at a slower pace than the fall in headline inflation, also contributing to household purchasing power.

In terms of inflation, this poses a risk of a more prolonged cost-push shock from wage growth. While this is unlikely to prevent goods disinflation, it would imply more persistent inflation in services. On average, services are much more labor-intensive and wages represent double the share of direct input costs than that of manufacturing firms. The strong labor market is therefore a major source of continued upside risks to the inflationary outlook.

While we forecast inflation in Europe will fall relatively quickly during the course of 2023 (in annual average terms), rates will remain relatively high. In the euro area, inflation will reach 6.1% and some CEE countries, especially Hungary, Czechia, Poland and Slovakia, will continue to see double-digit figures in 2023. 

In the euro area, inflation should reach the European Central Bank (ECB) target of 2% in the second half of 2024, but core inflation may remain higher until the second half of 2025. For many EU countries, price growth will remain above central bank targets until 2025 and for some countries, may last even longer. Moreover, in the environment of tight labor markets and continued very high inflation, the risk of another surge in price pressures due to new supply shocks remains significant.  

Therefore, central bank rates may stay higher for longer

It is worth mentioning that the current tightening cycle is already the strongest in ECB history and the Fed has not been this hawkish for over 40 years.

The ECB will maintain a data-dependent approach and, due to increased uncertainty over the effects of the recent turmoil in the financial sector regarding credit conditions, will refrain from providing guidance on the future interest rate path.

However, given that core inflation in the euro area has recently hit another record and labor markets remain very strong, in our view, for most ECB policymakers further rate hikes will be warranted. We expect the ECB deposit rate to be raised by another 75bps to 3.75%.

Following the latest rate increase (by 25bps to the 4.75-5% range), the Fed has turned significantly more dovish as a result of the turmoil in the US banking sector. Another 25bps hike in May 2023 seems likely and we also expect the Bank of England to raise its base rate once more, reaching a peak of 4.50%.

The 2023 economic outlook has improved, but the balance of risks leans to the downside

Persistent elevated inflation would squeeze household budgets for longer and impact private consumption, in addition to increasing the risk of excessive monetary policy tightening by major central banks that may prefer to err on the side of caution.

The recent turmoil in the banking system, beginning with the failures of some US banks, is a new cause for concern. However, given different financial supervision rules covering much smaller banks in Europe, the same situation is unlikely to occur. The most recent assessment conducted by the European Banking Authority confirms the strong position of European banks. 

Even prior to these developments, banks had already tightened credit standards, due to rising interest rates. The effects of monetary policy tightening have become apparent in the overall negative loan growth in the euro area for the first time since 2014, and a slowdown in new home construction in many countries. The full impact of interest rate hikes is yet to be felt fully. The latest events may make banks even more reticent in lending, which could weigh further on economic growth, although we do not know how significant or lasting this will be. Central banks, especially the ECB, will now be watching lending conditions more closely, which may reduce the scale of increased interest rates required. Pockets of vulnerability exist in the banking sector, but also may apply to non-bank financial institutions, which continue to play a growing role in global markets. 

In our baseline scenario, the banking turmoil will be contained, without significant impact on the European economy. However, volatility in market sentiment could continue, together with hunting for weakness, and more rigid lending standards increase the risk of overtightening by the ECB, which may later need to recalibrate its monetary policy.

In an alternative scenario, in which we assumed that the current turmoil leads to an additional tightening of credit conditions (a third as large as those during the global financial crisis), by 2025 GDP in the euro area would be almost 2% lower than in the baseline. 

Geopolitical tensions, including the war in Ukraine, continue to be a key risk and if they intensify, could lead to more energy and food price spikes (especially if the Black Sea Grain Initiative is not renewed), pushing inflation up. China’s reopening, while easing supply bottlenecks and supporting global growth, will add to price pressures through increased demand for energy commodities, especially natural gas. Potential harsh weather conditions could exacerbate imbalances in energy markets, particularly ahead of the next winter. The decision of OPEC+ members on 2 April 2023 to cut oil output only adds to the growing concerns over energy prices and economic outlook.

Our analysis shows that Europe is more vulnerable to a renewed increase in energy prices than other major economies, in particular the US. In the event of another spike in energy costs, the most adversely impacted European economies would include Romania, Hungary and Czechia.

Last but not least, elevated debt levels increase vulnerability, especially of emerging markets and developing economies, to potential financial market turbulence. They also limit the fiscal space to offset new negative shocks and their impact on households and businesses.