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EU Economic outlook - where are we heading?

In order to avoid any doubts about its price stability mandate, the ECB is again raising its key interest rates by 0.25 percentage points. But now the interest rate peak has been reached. Otherwise the risks to the economy would be far too great.

While the inflation sky in the Eurozone is slowly brightening,...

The ECB raised its key interest rate again by 0.25 percentage points to 4.5 percent. Given that inflation is currently still high, she didn't want to raise the white interest rate flag just yet.

But that was it now. The ECB assumes that key interest rates have reached a level that, if maintained long enough, will make a significant contribution to a timely return of inflation to the target value of 2.0. ECB boss Lagarde also emphasizes the significant delays with which interest rate increases affect the economy and inflation. The braking effects of the latest tightening are still on the way.

So the ECB knows that the time is in its favor or in favor of an interest rate break. This means that it can freely refer to the specific data available, on the basis of which it decides on further interest rate policy from meeting to meeting. Inflation has already halved to 5.3 percent within 10 months. And the rapid decline in producer prices, which now even has the character of deflation, indicates that consumer prices will continue to decline in the future. In general, the continued downward trend in core inflation is grist for the mill of an ECB that will cut interest rates from now on.

The increase in the ECB inflation forecasts for 2023 and 2024 (5.6 after 5.4 percent and 3.2 instead of 3.0 percent) should not be a cause for concern, as they are mainly due to higher energy prices. However, by lowering its forecast for 2025 to 2.1 percent from 2.2 percent, it shows that the disinflation trend is fundamentally intact.

In general, if it assumes average inflation in 2023 of 5.6, which is 6.7 for the months January to August, it obviously expects price rates to continue falling this year.

... the economic clouds are getting darker

Interest rate increases and liquidity skimming have a negative impact on the economy through sharply rising financing costs - the so-called “monetary policy transmission”. And this economic dampening also causes a loss of momentum when prices rise. In fact, when looking at the lowered growth projections (2023 0.7 instead of 0.9 percent; 2024 1.0 instead of 1.5 percent; 2025 1.5 instead of 1.6 percent) the arguments for interest rate restrictions lose even more force.

Last but not least, further interest rate increases threatened additional economic hardship: If inflation continued to decline, the long negative real central bank interest rate moved into positive territory at the end of the year. Loan interest increases can no longer be inflated away. They are becoming increasingly unattractive with all the negative consequences for economic growth. And then the pain for the completely over-indebted Euro countries increases. This now also includes Germany.

The short-term outlook for growth in the euro area has deteriorated, while over the medium term the economy should gradually return to moderate growth as both domestic and foreign demand recover. Euro area economic activity grew at a subdued paced in the first half of 2023, despite the elevated level of manufacturing order backlogs and the unwinding of high energy prices. Moreover, these effects have largely waned and short-term indicators point to stagnation in the near term in the face of tighter financing conditions, weak business and consumer confidence and low foreign demand in the context of a strengthening of the euro.

Growth is expected to pick up from 2024 as foreign demand approaches its pre-pandemic trend and real incomes improve, underpinned by declining inflation, buoyant nominal wage growth and still low, though slightly increasing, unemployment. However, growth will continue to be dampened as the ECB’s monetary policy tightening and adverse credit supply conditions feed through to the real economy and as fiscal support is gradually withdrawn. Overall, annual average real GDP growth is expected to slow down from 3.4% in 2022 to 0.7% in 2023, before recovering to 1.0% in 2024 and to 1.5% in 2025.

Compared with the June 2023 Eurosystem staff projections, the outlook for GDP growth has been revised down by 0.2 percentage points for 2023, 0.5 percentage points for 2024 and 0.1 percentage points for 2025, reflecting a significant downgrade of the short-term outlook, amid deteriorating survey indicators, tighter financing conditions – including more adverse credit supply effects – and the stronger euro exchange rate.

Graphic of the week

Industry in the Eurozone has shrunk significantly within a year. And service providers are now slipping right behind due to increased cost pressure due to wages and a simultaneous decline in demand. The mood among them has fallen to its lowest level since the 2021 corona pandemic. The Eurozone is entering winter recession.

The already enormous increase in insolvencies, especially among small and medium-sized companies, is also evidence of recession. Against this background, exaggerated demands for a 4-day week with full wage compensation become drastically less likely to be implemented if there are additional increases.

In the dilemma between price stability and economic stabilization, the ECB will no longer raise interest rates, will initially pause interest rates until next year and then carry out the first step in reducing interest rates. This assessment is also shared by a weaker euro. The financial markets will price in this prospect at an early stage and will help economic players by reducing lending rates again.

Market situation - Monetary policy is no longer a hot topic internationally either

In the USA, disinflation is losing steam due to recently higher gasoline prices. However, other inflation subcomponents such as food, goods, services and, above all, core inflation continue their falling trend.

The American labor market is also losing strength. The gap between job advertisements and the number of unemployed is increasingly narrowing, which suggests weakening wage growth and slowing the wage-price spiral.

According to the futures markets, the US Federal Reserve has completed its interest rate hikes. However, like the ECB, the Fed is likely to initially maintain its verbal interest rate threats in order to artificially limit inflation expectations. Rate cuts are expected from July 2024, but could also come earlier.

In general, there is no threat of a radical break with the fundamentally ultra-loose monetary policy of the Japanese central bank. With regard to over-indebtedness and aging in Japan, her hands are tied. It will therefore continue to perform its function as one of the most important sources of liquidity in the world.

Therefore, the massive lead in the earnings yield of stocks over the yields of 10-year government bonds in Japan remains safe and continues to serve as an important support for the Tokyo Stock Exchange.

Given the gradual easing of fears about inflation and interest rates, investors are once again turning their attention to growth stocks. Tech stocks in the second tier in particular are currently around 20 percent cheaper after their correction since the end of July.

Sentiment and chart technology DAX - Protected on the downside

Until recently, the stock market mood was rather reserved. However, according to a survey by Bank of America, easing fears of inflation and interest rates are causing relaxation among large institutional investors.

The strong demand for the IPO of the British chip designer ARM shows that the stock market and high-tech mood is fundamentally stable. After the horror year of 2022, investor interest in IPOs is increasing again and underlines the greater willingness to take risks on the stock exchanges.

The proportion of optimists minus pessimists in the US stock market also signals decreasing risk aversion. However, we are still a long way from extreme values, so the interim correction potential on the stock markets is limited.

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