2023 Mid-Year Global Economic Outlook

Europe/US divergence: the ECB has further to go

Eoin O'Callaghan, Macro Strategist
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The views expressed are those of the author at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.

This is an excerpt from our 2023 Mid-year Investment Outlook, in which specialists from across our investment platform share insights on the economic and market forces that we expect to influence portfolios in the second half of the year. This is a chapter in the Mid-year Global Economic Outlook section.

The recent spike in US financial stress and signs that the US Federal Reserve’s (Fed’s) tightening cycle is nearing an end raise the potential for increased economic divergence between the US and the rest of the world, as discussed in our global macro mid-year outlook. For Europe, the key questions are whether and for how long the euro-area cycle and monetary policy will diverge from the US. 

While recent financial stress could represent a downside risk to European growth, we continue to expect supportive policy throughout this year, as well as solid consumer and corporate fundamentals. Combined with growing signs of strong and increasingly embedded inflation, we think this backdrop continues to imply that the European Central Bank (ECB) may need to hike for longer than is being priced by the market. Below are the key considerations that inform this view.

  • US financial stress represents a new downside risk to growth in the euro area — So far, the impact on European consumer and business confidence, as well as European bank funding costs, appears to have been limited. But both risks need to be watched. A hit to confidence could arrest the recent reacceleration in growth surveys, while any rise in funding costs could exacerbate the recent slowdown in private sector credit growth, which, on an annualised basis, fell from 6% – 7% of GDP per month last summer to 1% of GDP during the first quarter of 2023. 
  • European banks look resilient on a relative basis — Whilst we need to monitor the risk of rising financial stress, European banks look relatively robust relative to the US on the liabilities side of the balance sheet — where there is less structural competition for deposits from money market funds. On the asset side, the ECB rather than the banking system has been the main absorber of government bond supply, taking down 100% of government net issuance over the past decade. 
  • Relatively supportive policy and consumer and corporate fundamentals underpin euro-area growth — Monetary policy is tightening but is still not that tight, while fiscal policy remains accommodative. Both consumer and corporate fundamentals are remarkably strong. Nominal income growth is running at a record high, and we expect real-income growth to accelerate through the year as headline inflation falls back towards 3% by the end of this year. Unemployment is also at a record low, while corporate profitability is increasing at an exceptional pace, with margins at their highest levels since before the global financial crisis. In short, without discounting downside risks, the fundamentals point to growth having more momentum than the ECB’s growth forecast assumes. 
  • Evidence of strong and increasingly embedded underlying inflation continues to build — Although core inflation for the euro area peaked in March at 5.7%, our projections imply that it will remain much stickier than the ECB expects due to persistently strong price rises in core services and record wage growth. Our core forecast for 2023 and 2024 is about 0.5 – 0.6 percentage points above the ECB’s projection. The rebound in three-year-ahead consumer inflation expectations in March to nearly 3% — despite the recent weakness in energy prices — also hints at inflation becoming more engrained. The strength of the data compared with the US remains striking — both core inflation and wage growth are running higher. We still anticipate that inflation in the euro area will exceed US and G7-average inflation over the coming years. 
  • The ECB could hike for longer, with upside risk to market pricing — The ECB’s decision to slow the pace of interest-rate rises to 25 basis points at its meeting in May shows some sensitivity to the recent slowdown in credit growth and the risks associated with recent financial stress. Nevertheless, its own forecast is consistent with a terminal rate of up to 4.0%, and the risks to those projections, to us, feel skewed to the upside. 

If financial stress were to intensify, that would create some non-policy-induced tightening. However, in the absence of such an adverse scenario, the ECB is likely to keep normalising rates into the autumn. Real rates also suggest upside risk to the amount of tightening the ECB needs to undertake. As illustrated in Figure 1, deflated by consumer medium-term inflation expectations, real rates are only 0.35%, well below the 2% equivalent level in the US. 

On balance, investors should therefore prepare for divergence to continue, with varying implications for asset prices in the euro area and beyond. 

Figure 1


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