Key views on Global Monthly - How vulnerable is the economy to a sharp fall in house prices?
The energy crisis in Europe is tipping the eurozone and UK economies into recession. Consumption growth is being weighed by the biggest fall in real incomes in decades, while industry is being hampered by sky-high energy prices and worries over potential shortages as we move into the winter months. Housing markets are also correcting on the back of surging mortgage rates. Governments are stepping in more aggressively to help households and businesses, but high inflation means that central banks may need to tighten monetary policy even further to offset this. Upside inflation risks mean the Fed and ECB are in any case likely to continue raising rates rapidly at coming meetings. Europe will also continue to feel the global spill-over effects of much tighter US monetary policy, pushing bond yields higher, equity markets lower, and weighing on growth.
Macro
Eurozone – The economy has moved into recession. We have pencilled in a modest contraction in GDP in Q3 and two more significant contractions in 2022Q4 and 2023Q1. We expect annual average growth to be 2.7% in 2022 and -0.9% in 2023. Inflation reached a new record high level of 9.9% in September. We expect it to have peaked and decline noticeably in coming months on the back of lower food and energy price inflation. We have lowered our forecast for inflation in 2022 to 8.0% (down from 8.3%) and in 2023 to 4.0% (down from 4.4%).
Netherlands – Since the start of this year we expect the Dutch economy to slow down at the end of 2022, ultimately leading to a small contraction at year’s end. Supportive of this view we see the first cracks appear at the end of the third quarter in the form of slower economic activity and faltering demand. The generic support from the government’s energy price ceiling, and the fact that the package is redistributive, means that we expect a smaller hit to consumption next year than anticipated earlier. On the back of this, we have lifted our growth forecasts for 2023 by 0.2 pp: from 0.5% to 0.7%.
UK – Despite the political chaos, the news flow has been largely positive from a policy point of view, and a crisis looks to have been averted. Most mini-budget measures have been scrapped, and the new government is likely to be fiscally hawkish. The outlook for the economy is still bleak, however. Demand has continued to weaken on the back of record low consumer confidence, and fiscal policy now looks set to be tightened significantly, compounding the impact of monetary tightening. We continue to expect a recession over the coming 12 months.
US – GDP revisions show that the Covid recession was shallower, and the recovery stronger than initially estimated. This suggests less room for further recovery than we thought. Labour market data points to softening demand. Other pipeline inflationary pressures are also easing. However, core inflation is likely to remain alarmingly high for the next few months. We expect underlying demand to cool further into 2023, as the decline in real incomes and interest rate rises begin to bite. Soft demand is likely to push the unemployment rate higher, with the NBER likely to declare a recession next year.
China – The CCP’s 20th National Congress resulted in a third term for Xi as party leader, paving the way for a third presidential term. We do not expect a sharp turn in Covid-19 policy soon, but Beijing may adopt a more pragmatic approach in the course of 2023. Coupled with drags from real estate, a global growth slowdown and the flaring up of US-China tech tensions, downside risks have risen. We cut our growth forecasts for 2022 (to 3.5%, from 3.7%) and 2023 (to 5.2%, from 5.6%), despite the expected supply-driven Q3 GDP rebound from the Q2 lockdown slump.
Central Banks & Markets
ECB – Following the 75bp rate hike at the September meeting, we expect another 75bp rate hike in October, followed by a final 50bp hike in December. This will take the deposit rate to 2%, where we expect it to peak. We have not pencilled in any rate hikes after that as the economy is expected to move into recession. This should do much of the heavy lifting in terms of fighting inflation. The risks to our forecast for ECB policy are skewed to more rate hikes in the 3-6 month horizon, given that the ECB's focus is on inflation rather than growth.
Fed – Given persistently elevated inflation in the US, and upside risks to the outlook, we expect the Fed to hike rates a further 75bp in November, and 50bp in December, with the upper bound of the fed funds rate to peak at 4.5%. Subsequently, we expect the Fed to pause, assuming inflation is moving lower and the labour market deteriorates. Near-term risks are to the upside, both in the rate hike pace and in the peak rate. Further out, we continue to expect modest rate cuts in H2 23. In the background, the Fed continues to unwind its balance sheet at a $95bn monthly pace.
Bank of England – The growing risk of a wage-price spiral in the UK led the MPC to hike rates by 50bp at the September meeting. We now expect a 75bp hike in November, with Bank Rate to peak at 4% by early 2023. Fiscal policy U-turns have significantly reduced the risk of more aggressive rate hikes, and the MPC is now unlikely to follow through on market pricing of Bank Rate rising to 5%. We expect a further unwind of rate hike expectations, as more MPC members attempt to steer a pullback in expectations given the very weak growth outlook.
Bond yields – We judge that the peak is in sight for German bunds (if not already reached), given the sustained rise in yields in recent weeks while economic indicators are already showing signs of contraction. On the US side, sticky inflation has led markets to price in further Fed rate hikes, with markets expecting the fed funds rate to peak at 5% by mid-2023. As such, we think there is still some room for Treasury yields to move slightly higher from here before retreating around the end of this year on the back of weaker growth indicators and cooling inflation.
FX – An energy crisis and a recession in the eurozone combined with a more aggressive path of rate hikes in the US compared to the eurozone will probably keep the euro under pressure versus the US dollar this year. The recent wave of risk aversion pushed EUR/USD below parity due to safe haven demand for the dollar. When financial markets calm down somewhat again, lower safe haven demand for the dollar could result in a recovery of EUR/USD. Our forecasts for EUR/USD for end 2022 stands at 1.0.