Challenges for the euro zone

The euro zone seems set for a significant slowdown as supply chain strains continue to hobble Germany in particular, while surging inflation, especially in energy, undermines consumer finances across the region. Recession seems certain, should the Russia-Ukraine conflict result in a sudden curtailment of Russian gas supply to the euro zone. But even without such a shock, the region could still be teetering on the edge of recession soon.

Mr. Steve Barrow, Head of Standard Bank G10 Strategy expects euro zone’s GDP growth this year to be 2%, with 1% growth in 2023. That’s distinctly on the lower side of most forecasts, such as the 2.8% (for 2022) and 2.3% (for 2023) recently projected by the IMF in its April World Economic Outlook.

"A particular difficulty for the euro zone is that trade has collapsed, not providing the same support to growth as before, partly because supply chain tensions are hurting exporters. Prior periods of tension, such as the 2008 global financial crisis and the 2010–12 euro zone debt crisis, resulted in much stronger trade as demand weakness pulled down imports. But now, growth weakness is stemming from the supply side as well, and that’s hurting export prospects, particularly Germany’s", Mr. Steve Barrow said.

Even if trade does recover, it will take considerable time to return to the monthly trade surpluses of over EUR20bn per month that were a feature of the pre-Covid economy. High inflation in the euro zone is also eating into the region’s international cost competitiveness. Current CPI inflation is at 7.4%, nearly four times the ECB’s 2% target. Still, a higher proportion of this rise is down to the energy and food price inflation stemming from the conflict in the Ukraine than in the US, for instance.

Hence, if these energy and food price increases prove temporary, it seems reasonable to assume that price pressures will dissipate more quickly in the euro zone than in the US and many other countries. A corollary to this is that the ECB may prove to be far more cautious in its monetary tightening than the likes of the Fed and many G10 central banks. But all this assumes an early end to energy and food price strains and, as far as we can tell, this might be wishful thinking. For a start, transitioning away from Russian energy supply will likely prove costly, and then there is the transition away from fossil fuels.

In short, rather than treating the rise in energy prices as a temporary disturbance that the ECB can "look through" with its monetary policy, the bank seems likely to see the increase as more permanent, and should adjust policy accordingly. The market anticipates that the ECB will start lifting its (lower) deposit rate in the second half of the year once it has ended asset purchases (likely in Q3). The next set of ECB forecasts to be released in June will be critical in this regard.

Mr. Steve Barrow said if the ECB predicts inflation above target throughout the whole forecast horizon, the way should be clear to start inching policy rates higher. The key here is the idea that rates will be "inched" higher because he doubts that the bank will employ the sort of rapid rate hikes that the Fed seems set to announce. The prospect of wider rate spreads between the US and the euro zone may suggest a weaker euro, as does the very sharp deterioration in the euro zone trade balance. However, the euro has held up quite well so far, and one thing we should consider is that rising yields in the euro zone might lag the US, but we will see lots of bonds move out of the negative-yielding category. Negative yielding euro zone debt nearly topped EUR 8 trillion last year but has now practically disappeared.

These negative yields have contributed to nearly EUR600bn of net capital outflows from the euro zone debt markets in the past year as domestic investors sought positive yields abroad and foreign investors grew tired of the low rates in the euro zone. "But now that the tide has turned on negative yields, we should see these flows reverse, and that could help cushion the euro over the longer term. In the short term, meaning the next few months, the euro does risk a slide to 1.0-1.05, but, over the longer haul, we’d see a rebound to 1.25 in two years, partly due to "helpful bond flows," Mr. Steve Barrow forecasted.