H3>Eurozone Economy Delivers Disappointing Data
Eurozone economic data have been broadly downbeat in recent months, a trend capped by the region’s third quarter GDP report. Q3 GDP surprised to the downside, dipping 0.1% quarter-over-quarter, although an upward revision to Q2 GDP provided a partial offset. Growth in the region’s largest economies was subdued, as German GDP fell 0.1%, Italian GDP was flat and French GDP edged up just 0.1%. With recent activity and survey data remaining soft, the natural question to ask is whether the Eurozone is on the cusp of—or perhaps already in—recession. In this report we take a look at updated consumer and business fundamentals to offer some perspectives on those questions.
Consumer Slowdown May Be Passing The Worst
One notable area of weakness has been consumer spending, which has declined by a cumulative 0.6% in the three quarters through Q2-2024, the latest quarter for which full data are available. Moreover, the indications for third quarter spending are not encouraging. Retail sales fell in both June and July, and the average level of sales for the July-August period is down 0.6% compared to Q2. That said, we believe the worst of the consumer slowdown may be coming to an end. As headline inflation has receded, real household disposable income has returned to positive territory during this first half of this year. For Q2, real household disposable income rose 1.4% year-over-year, outpacing the 0.4% year-over-year increase in real consumer spending. Our outlook is for growth in real household incomes to continue, and perhaps strengthen slightly further, through the rest of 2023 and into 2024. We see continued employment growth, though perhaps at a somewhat more gradual pace than recently. We note that while the European Commission’s Employment Expectations Indicator (EEI) has softened, it has held up better than the broader Economic Sentiment Indicator. Indeed, the EEI remains above its long-term average from 2000 to 2022, and its October reading of 102.8 is historically consistent with employment growth of around 1% per year. With labor costs still growing by around 4.5%-5.5% and with inflation likely to decelerate somewhat further, we anticipate some further firming in real income growth going forward. We also note the household saving rate rose to 14.9% of disposable income in Q2, and remains moderately above pre-pandemic levels, providing Eurozone consumers some capacity to spend. Finally, we observe that household interest costs have risen only moderately over the past several quarters, to 2.1% of household disposable income by Q2-2023. Overall, while we don’t necessarily envisage a sharp rebound, these moderately favorable household finance fundamentals should, in our opinion, prevent a significant further decline in consumer spending.
Business Outlook Gradually Softening
While we believe the consumer outlook may be passing the worst, we see potential for a moderate further weakening in the business outlook across the Eurozone and, as a result, possible weakness in investment spending in the quarters ahead. Eurozone corporate profits have held up reasonably well so far, but are showing signs of softening. Net Entrepreneurial Income (which, according to Eurostat, broadly approximates pre-tax corporate profits) grew 1.4% year-over-year in Q2-2023, the latest available data. On the positive side, corporate profits have not shown an outright decline so far, though on the more negative side, profit growth has slowed noticeably over the past year. How might these gradually worsening trends for Eurozone businesses affect employment growth and investment spending? As we highlighted above, the gradually softening in business environment has led to only a moderate slowdown in employment growth. We expect job gains can continue in the quarters ahead, albeit at a slower pace than recently. With respect to investment spending, we believe a range of recent indicators point to some decline in investment spending in the quarters ahead. For the Eurozone, a precise measure of business fixed investment is not readily available. We can, however, estimate a measure that broadly approximates that metric, and for which we believe investment cycles are broadly similar. Specifically, we calculate Eurozone investment spending excluding dwellings (or housing) investment and excluding intellectual property products. We exclude dwellings on the basis that it is clearly related to households and not businesses. While spending on intellectual property products is clearly relevant for business investment, it is also a particularly volatile series, and its removal allows for a clearer sense of underlying investment trends. Fortunately our estimated metric, which we define as “Core ex-Housing Investment”, shows a similar but less volatile cycle than overall Eurozone investment spending. While growth in core ex-housing investment has slowed, it was still up 2.9% year-over-year in Q2-2023. That said, trends in Eurozone net entrepreneurial income (or corporate profits) point to a further slowdown in core ex-housing investment ahead. Historically, Eurozone profit growth and investment growth cycles have followed reasonably similar patterns, and thus the slower growth in corporate profits also portends a downturn in investment spending. That would especially be the case if Eurozone profit growth turns negative, which is clearly a distinct possibility. We also see some other indicators than reinforce the outlook for an investment spending slowdown. In particular, Eurozone capacity utilization measures have fallen in recent quarters, a trend that would suggest a slowdown in investment spending. That decline in capacity utilization has been most evident in the manufacturing sector, from 82.8% in Q1-2022 to 79.4% by Q4-2023. Historically, a capacity utilization rate of below 80% for manufacturing has been consistent with declining core ex-housing investment for the Eurozone. Capacity utilization in the service sector has also softened, though only slightly, from 90.9% in Q3-2022 to 90.1% by Q4-2023. Finally, Eurozone bank lending to non-financial corporates slowed to just 0.2% year-over-year in September, also an indirect indicator of slower investment spending ahead. Overall the mixed outlook for consumer and investment spending leaves the Eurozone very close to recession, and largely dependent on whether the improvement in consumer spending transpires more quickly than any investment spending slowdown. Among the indicators we will be monitoring most closely are monthly retail sales and quarterly corporate profits and capacity utilization. Moreover, while we are not calling for Eurozone recession just yet, should the Eurozone PMI surveys stay at their current contractionary levels in the months ahead or soften further, an economic downturn may eventually become unavoidable.
Eurozone Rate Hikes Are Done, Monetary Easing Still Some Way Off
Regardless of whether the Eurozone falls into recession, we see enough growth headwinds to suggest that the European Central Bank’s (ECB) monetary tightening is done. At its October announcement, the ECB held Deposit Rate at 4.00% and repeated that interest rates are at levels that…
