Euro-Area Economy Stalls: Recession Fears Rise as ECB Decision Looms

Global markets will be dominated by the ECB's monetary policy meeting and Eurozone inflation data, UK economic data and political developments, and ongoing geopolitics

Wednesday, 17 July, Week 29

The Fiscal Tightrope: Balancing Support and Sustainability

The Euro Area's fiscal policy has been navigating a delicate balance between supporting a fragile economy and addressing concerns about debt sustainability. Over the past five months, governments have grappled with the unwinding of pandemic-era support measures, the impact of the energy crisis, and new spending pressures stemming from the war in Ukraine and the green transition. This has resulted in a tightening of the fiscal stance, particularly in 2024, as governments withdraw energy and inflation support measures. The European Commission's Spring 2024 Economic Forecast projects a significant tightening of the fiscal stance in 2024, "owing mainly to the withdrawal of a large part of the energy and inflation support measures." The report also notes that "the withdrawal of fiscal support measures introduced since 2022 to compensate for high inflation and energy prices will, overall, have a small negative impact on growth in 2024-26."

The current fiscal policy can be characterised as cautious consolidation. While governments are withdrawing some support, they are also mindful of the need to avoid undermining the nascent economic recovery. The focus is on gradually reducing deficits while preserving investments in key areas such as the green and digital transitions. Looking ahead to the next five weeks, fiscal policy is likely to remain in the background as attention shifts to the ECB's monetary policy decision and incoming economic data. However, any significant deviation from the projected fiscal path, either towards more expansion or more aggressive consolidation, could impact market sentiment and the EUR's valuation.

Fiscal policy plays a crucial role in shaping the macroeconomic environment by influencing aggregate demand, public debt levels, and long-term growth prospects. A prudent fiscal policy can contribute to macroeconomic stability by creating fiscal buffers that can be used to cushion the economy during downturns. It can also support long-term growth by fostering investment in infrastructure, education, and research. Conversely, an excessively loose fiscal policy can lead to unsustainable debt levels, higher interest rates, and crowding out of private investment.

A Patchwork Recovery: Navigating Uncertainty

The Euro Area's economic recovery has been uneven and fragile, marked by headwinds from the energy crisis, the war in Ukraine, and persistent inflation. Over the past five months, the region has experienced sluggish growth, with Germany entering a technical recession in the first quarter of 2024. The latest economic data paint a mixed picture, with some indicators pointing to a potential pickup in activity while others suggest continued weakness. The June 2024 Eurosystem staff projections highlight this uncertainty, noting that "incoming information suggests continued growth in the short run, at a higher pace than previously foreseen," but also acknowledging that "headwinds to global growth remain." The June Sentix report states that "the recent recovery of the European economy has come to an abrupt end" and that "the sentix economic index for the eurozone fell by a whopping 7.6 points in July."

The Euro Area's economic situation can be characterised as a tentative recovery facing significant challenges. While the worst of the energy crisis appears to be over, the war in Ukraine continues to cast a long shadow, and inflation remains elevated. The outlook for the next five weeks is clouded by uncertainty surrounding the ECB's monetary policy decision, the path of inflation, and the global economic environment. Key economic data releases, such as the preliminary GDP estimate for the second quarter, inflation figures for July, and the August PMI readings, will be closely watched for clues about the strength and sustainability of the recovery.

The economic indicators listed below provide a snapshot of the Euro Area's economic performance and outlook:

Economic Growth:

• Euro Area GDP Growth Rate QoQ: Measures the quarter-on-quarter change in real GDP. The previous result was 0.30%, the consensus is 0.20%, and the forecast is 0.30%. The Euro Area economy has been growing at a modest pace in recent quarters, with the first quarter of 2024 showing a slight acceleration. The outlook for the second quarter is uncertain, with the potential for a slowdown due to the impact of the ECB's monetary policy tightening.

• Euro Area GDP Growth Rate YoY: Measures the year-on-year change in real GDP. The previous result was 0.40%, the consensus is 0.70%, and the forecast is 0.40%. The Euro Area economy has been growing at a subdued pace in recent quarters, with the first quarter of 2024 showing a slight acceleration. The outlook for the second quarter is uncertain, with the potential for a slowdown due to the impact of the ECB's monetary policy tightening.

Labour Market:

• Euro Area Unemployment Rate: Measures the percentage of the labour force that is unemployed. The previous result was 6.40%, the consensus is 6.90%, and there is no forecast data available. The Euro Area unemployment rate has been declining in recent months, reaching a record low in April 2024. However, the pace of job creation has slowed, and the outlook for the labour market is uncertain given the fragile economic recovery.

Inflation:

• Euro Area Inflation Rate YoY: Measures the year-on-year change in the Harmonized Index of Consumer Prices (HICP). The previous result was 2.50%, the consensus is 2.50%, and the forecast is 2.20%. Euro Area inflation has been declining in recent months, but it remains above the ECB's 2% target. The outlook for inflation is uncertain, with upside risks from higher energy prices and persistent core inflation.

• Euro Area Core Inflation Rate YoY: Measures the year-on-year change in the HICP excluding energy and food. The previous result was 2.90%, the consensus is 2.80%, and there is no forecast data available. Euro Area core inflation has been sticky in recent months, indicating persistent underlying price pressures. The outlook for core inflation is uncertain, with upside risks from higher wages and strong demand for services.

Trade:

• Euro Area Balance of Trade: Measures the difference between the value of exports and imports. The previous result was €13.9B, the consensus is €18B, and the forecast is €18.0B. The Euro Area has been recording trade surpluses in recent months, driven by strong export performance. However, the outlook for trade is uncertain, with downside risks from weaker global demand and escalating trade tensions.

Business Confidence:

• Germany Ifo Business Climate Index: The Ifo Business Climate indicator for Germany unexpectedly declined to 88.6 in June 2024 from 89.3 in May, below forecasts of 89.7. The expectations gauge went down to 89 from 90.4 while the current outlook steadied at 88.3. The readings showed sentiment has deteriorated at companies and the German economy is having difficulty overcoming stagnation. In manufacturing, the business climate declined after three rises in a row. Business sentiment also deteriorated in trade while service providers assessed their situation more positively and constructors showed less pessimistic expectations.

• Sentix Economic Index for the Eurozone: The sentix Economic Index for the Eurozone fell to -7.3 in July 2024. The report states that "the recent recovery of the European economy has come to an abrupt end" and that "expectations slumped by 8.5 points to 1.5 points."

Consumer Sentiment:

• Euro Area Consumer Confidence: Measures consumer confidence in the economic outlook. The previous result was -14, the consensus is -13.6, and there is no forecast data available. Euro Area consumer confidence has been improving in recent months, but it remains at a low level. The outlook for consumer confidence is uncertain, with downside risks from high inflation and the war in Ukraine.

The Monetary Policy Crossroads: Data Dependence and Uncertainty

The ECB's monetary policy has undergone a significant shift over the past five months, moving from aggressive tightening to a more cautious and data-dependent approach. After raising interest rates at every meeting between July 2022 and September 2023, the ECB lowered rates by 25 basis points. This decision was driven by signs of cooling inflation, a weakening economic outlook, and concerns about the impact of past rate hikes on growth and financial stability. The ECB's June 2024 monetary policy statement emphasised this shift, stating that "it is now appropriate to moderate the degree of monetary policy restriction" and that "we will continue to follow a data-dependent and meeting-by-meeting approach to determining the appropriate level and duration of restriction." The minutes from the June meeting show that "ECB policymakers raised some doubts about whether the Euro Area recovery would take place as expected, since it depended on a pick-up in private consumption for which there was no convincing evidence in the data yet."

The current monetary policy can be characterised as restrictive but flexible. While interest rates remain at elevated levels, the ECB has signalled its willingness to adjust its policy stance in response to incoming economic data. The focus is on bringing inflation back to the 2% target while avoiding an excessive slowdown in economic activity. The outlook for monetary policy over the next five weeks is uncertain, with the ECB's decision hinging on the path of inflation, the strength of the economic recovery, and the evolution of financial conditions. The ECB's monetary policy meeting on Thursday will be a key event, as the market will be looking for clues about the central bank's assessment of the economic outlook and its policy intentions.

Monetary policy is a crucial tool for managing inflation, influencing economic growth, and maintaining financial stability. By adjusting interest rates and other monetary policy instruments, the ECB can influence borrowing costs, investment decisions, and consumer spending. A restrictive monetary policy can help to curb inflation by dampening demand, but it can also weigh on economic growth. Conversely, an accommodative monetary policy can support growth but may also lead to higher inflation.

Storm Clouds Gathering: Risks to the Outlook

The Euro Area's macroeconomic outlook is subject to a number of risks that could derail the recovery and reignite inflationary pressures. Three key risks have shaped the economic and market landscape over the past five months:

• US Inflation Rollercoaster (March - July 2024): Persistent inflation in the US has been a major source of uncertainty for global markets. While recent signs of cooling inflation have raised hopes of a potential Fed pivot towards rate cuts, recent hawkish comments from some Fed officials suggest a more cautious and data-dependent approach. This tension between cooling inflation and the Fed's uncertain policy trajectory has injected volatility into the USD's path.

  • Key Developments:

    • US CPI peaked at 3.5% in April before easing to 3% in June.

    • Core PCE inflation, the Fed's preferred gauge, slowed to 2.6% in May.

    • Markets are pricing in a September rate cut by the Fed, with two more reductions expected before year-end.

• Eurozone Stagnation (January - June 2024): The Eurozone economy has been grappling with sluggish growth, weighed down by the energy crisis, the war in Ukraine, and persistent inflation.

  • Key Developments:

    • Germany entered a technical recession in Q1 2024.

    • The Eurozone composite PMI has been hovering around the 50 mark, indicating weak growth.

    • The ECB cut interest rates by 25 bps in June, ending nine months of holding rates steady.

• UK Political and Economic Uncertainty (May - July 2024): The UK has been facing a period of political and economic uncertainty, marked by a change in government, a cost-of-living crisis, and persistent inflation. This has weighed on the GBP, making it vulnerable to swings in risk sentiment. The Bank of England has been raising interest rates to combat inflation, but the impact on the economy remains uncertain.

  • Key Developments:

    • The Labour Party won the general election in July, ending 15 years of Conservative rule.

    • UK inflation returned to the BoE's 2% target in May, but core inflation remains elevated.

    • The BoE maintained the Bank Rate at 5.25% in June, but some policymakers advocated for a cut.

Looking ahead to the next five weeks, three key risks could impact the Euro Area economy and relevant markets:

• ECB Decision and Eurozone Inflation (18th-19th July): The ECB's monetary policy meeting on Thursday will be a major focal point for the market. The ECB is widely expected to hold interest rates steady, but any hints about the future path of monetary policy could impact the EUR. Eurozone inflation data will also be closely monitored, as persistent inflation could prompt the ECB to adopt a more hawkish stance.

• UK Economic Data and Political Developments (Weeks 29-33): The UK economy will be in focus over the next five weeks, with key data releases such as CPI, employment, and retail sales due. Weaker than expected data could weigh on the GBP, while stronger data could provide support. Political developments, such as the new Labour government's policy announcements, could also impact the GBP.

• Geopolitical Headlines and US Election Jitters (17th-21st July): Geopolitical developments, such as the ongoing war in Ukraine and tensions in the Middle East, could impact risk sentiment and influence currency valuations. Additionally, any headlines related to the upcoming US election could inject volatility into the market.

Conclusion: A Summer of Uncertainty

The Euro Area economy is at a crossroads. The recovery remains fragile, inflation is still elevated, and the outlook for monetary policy is uncertain. The next five weeks will be crucial in determining the direction of the economy and the euro's valuation. Key events to watch include the ECB's monetary policy meeting on Thursday, the release of preliminary GDP data for the second quarter, and inflation figures for July. Forex traders should also keep a close eye on geopolitical developments, US economic data, and the UK's economic and political landscape.

Sources

• Eurostat

• European Central Bank

• European Commission

• Trading Economics

• S&P Global

• Sentix

• Federal Statistical Office (Germany)

• INSEE (France)

• Centre for European Economic Research (ZEW)

• GfK Group

• Ifo Institute