Macro Outlook 2023

Europe is facing a challenging year due to expected economic contraction, the US is likely to show only modest growth and China will no longer achieve its own ambitions for growth. Six forecasts about the world economy.

 Outlook 2023: six economic forecasts:

  1. Europe will enter into a recession

  2. The US will (just about) avoid an economic contraction

  3. China will no longer achieve its own ambitions for growth

  4. Fears of 1970s-style stagflation are premature

  5. Differences in Eurozone country bond yields will (eventually) be brought under control

  6. Calm will return to the UK interest rate markets

1. Europe will enter into a recession

As far as the economy is concerned, 2023 will be a tough year for Europe. Institutions such as the International Monetary Fund (IMF) and European Central Bank (ECB) are still forecasting growth of 0.5% to 0.9% in the Eurozone. This seems rather optimistic and will probably be adjusted downwards. A recession of two consecutive quarters of negative growth is in fact likely. As a result, growth over 2023 as a whole will almost certainly be marginally negative.

The European economy held up well until the third quarter of 2022. Among other things, the reopening effects following the pandemic helped growth to exceed expectations. Yet these effects are gradually dissipating and being supplanted by the negative impact of high inflation. This is primarily being driven by the high energy prices. The higher prices are pushing up wages but not enough to keep purchasing power at the same level. Moreover, the prevailing energy uncertainty is eating away at the confidence of both consumers and businesses. This all serves to curb economic growth.

There is unfortunately no sign of the war in Ukraine being brought to a speedy conclusion and this means energy will remain expensive for the time being. European countries have succeeded in restocking their gas reserves over the past few months but will need to repeat the process next spring and summer in order to be prepared for the winter of 2023-2024. Drastically reduced supplies from Russia will make this much more difficult and lead to volatile but persistently high prices. 

Supplies are tight on the oil market as well. This is due to the underinvestment of recent years and the stance of oil-producing countries (OPEC), which are cutting total production. On top of all this there is the tighter monetary policy from the European Central Bank. The constraining effect of higher policy interest rates will gradually trickle down into the economy and slow growth.

Does that mean there is nothing positive to say at all? No, of course not. Take the investments from the Recovery fund that the European Union launched during the pandemic. Or the financial support governments are providing to families and businesses to ease the crisis caused by high energy prices, although the flip side here is that this support risks prolonging inflation.   

2. The US will (just about) avoid an economic contraction
Like the Eurozone the US is having to contend with a high rate of inflation, but there are fundamental differences between the two economic regions. The US is self-sufficient when it comes to energy. This is not preventing prices from rising but does mean they are climbing less sharply and without the added uncertainty surrounding supply. 

In a sense the US finds itself in a normal economic cycle and the Federal Reserve, the US central bank, is responding by raising interest rates in order to prevent further overheating of the economy. It is worth noting the exceptional reason for the overheating this time around: the (more than) generous government support during the pandemic.

The Federal Reserve’s interest rate hikes will gradually have a constraining effect on the economy. The moderate growth of real wages is resulting in a drop in domestic demand. Exports will probably also lose momentum as economic growth slows around the globe. At the same time, the strong US dollar makes it expensive for anyone outside the country to buy US products. 

We estimate economic growth of 0.5% for the US next year. While this is moderate, there is less downside risk than in Europe where growth is likely to dip below zero. Nevertheless, the US experiencing two consecutive quarters of negative growth (the official definition of a recession) remains a realistic scenario. If, however, the rate of inflation is brought under control relatively quickly and the job market remains robust, the rate of growth could be much higher.   

3. China will no longer achieve its own ambitions for growth
The Chinese economy still finds itself in difficulties. The problems in the real estate sector and the zero-Covid policy continue to squeeze the economy. For 2023 we forecast growth of 3% to 4%, far below the country’s own target of 5% to 6%. Only if the Chinese authorities relinquish their zero-Covid policy will this target come within reach again. 

The rest of Asia is being adversely affected by the difficult conditions in China. Major export economies, such as South Korea or Taiwan, have already been experiencing a headwind since Western spending patterns normalised after the coronavirus pandemic: we are no longer buying goods en masse and instead spending more money on services. Incidentally, this is something that is impacting China itself as well.

There are also questions surrounding the longer-term outlook for China. Beijing’s crackdown on its own tech sector continues, for instance. This is restricting enterprise and in turn economic progress. Strangely enough, this clashes with the ambitions of President Xi Jinping, who wants to make China technologically self-sufficient and for the country to occupy a top international position in this respect. The West’s increasingly tough stance against China is not helping here either, as demonstrated by the export restrictions on high-grade technology recently imposed by the US government.

China has only grown in importance to the global economy since its accession to the World Trade Organization in 2001. And of course it continues to be important, thanks to its size and the trade relations that have been forged in the interim. Yet the tougher political position of both China and the West as well as the increased unpredictability of Chinese economic policy are causing many Western businesses to move some of their operations to other countries. This is illustrated by the fact that direct Chinese investments by European companies were down by 12% in 2022.

China is also grappling with an ageing population. By around 2030 the working-age population will have decreased by about 50 million. By the time we reach 2050 it will have shrunk by a fifth. These conditions make it all the more important to boost labour productivity in order to maintain growth. Beijing’s increasingly centralised control of the economy and the country’s reduced access to Western technology will not make this task any easier.     

4. Fears of 1970s-style stagflation are premature
Eurozone inflation is likely to peak at the end of 2022. Rates will probably remain high for some time but not climb further, as long as energy prices (gas in particular) do not deviate too much from their current levels. This continues to be the biggest uncertainty. 

If economic growth slows marginally, the core rate of inflation (i.e. inflation excluding energy and food) will fall to a more reasonable level. Not that this will immediately bring the European Central Bank’s target rate of inflation, a ‘healthy’ 2%, within reach. The sizeable government support aimed at compensating the high energy bills of consumers and businesses is having an inflationary impact, as did the stimulus packages during the pandemic.

We nevertheless do not expect a return to the 1970s, a decade that saw several years of stagflation, a combination of high inflation and stagnating economic growth. One major cause of this was the infamous wage-price spiral: high prices lead to higher wage demands, which lead to the higher wage costs being added to prices that in turn lead to higher wages and so on. Wages are rising at the moment but not to the extent that points to this kind of wage-price spiral. 

In the Eurozone, the current round of collective labour agreements is pushing up wages by an average of 3%. This is a sustainable rate of increase if we assume a ‘healthy’ rate of inflation of 2% and an annual upturn in productivity of 1%. A general rule of thumb tells us that the sum of these two is the margin for higher wages without inflation getting structurally out of hand. Naturally, there is a risk of wages rising more quickly but this is restricted by the slowing economy, the diminished power of the trade unions and the mitigating effect of many years of globalisation.   

5. Differences in Eurozone country bond yields will (eventually) be brought under control
In 2022 the spread on 10-year Italian bond yields compared to their German counterparts increased from 1% to 2.5%. Although this is lower than during the euro crisis (when it was over 5%), it does point to potential tensions in the Eurozone. Tough economic conditions, tighter monetary policy and the disparate impact of the energy crisis on individual countries could exacerbate these tensions in the coming months.

Whether this happens - and to what extent - depends partly on the new Italian government’s budget plans. These do not yet seem to be excessive but that could change at any time as Prime Minister Giorgia Meloni heads a government comprising populist parties.

At EU level, the debate on adjustments to the Stability and Growth Pact, the regulatory framework that limits government deficits and public debt levels, will kick off in the next few months. These rules have been suspended until the end of 2023 but everyone is well aware that a return to the old norms of a 3% deficit and 60% public debt is unrealistic. The cuts that would be required to quickly reach these norms would plunge the economy into a deep recession and probably trigger severe political unrest. Opinions vary as to what the new framework ought to look like. Southern European countries are in favour of customised rules for each individual country. Germany wants to keep to general rules for all countries. 

Whatever framework is ultimately thrashed out will determine the extent to which the Eurozone reverts to budgetary austerity. This decision will have an impact on the economy. The experience in the wake of the euro crisis, when stricter budgetary policies curbed the recovery, will result in a desire to restrict that impact as far as possible. This in turn begs the question of how financial markets will respond. They recently demonstrated to the UK that they will punish excessively expansionary financial plans by pushing up bond yields. 

In short, we cannot rule out fresh tensions on the capital markets of the weaker Eurozone countries. One significant difference from the euro crisis is that the European Central Bank has now set up instruments to keep such tensions under control. This includes programmes to buy up specific bonds issued by those countries that come under fire.

6. Calm will return to the UK interest rate markets
The United Kingdom experienced a turbulent few weeks after Liz Truss became prime minister on 6 September. While the UK’s central bank had already been raising policy interest rates for some time owing to the high rate of inflation and tight job market, the new prime minister announced a highly expansionary budgetary policy of €50 billion in unfunded tax cuts. The lack of clarity about where the money was supposed to come from pushed up borrowing costs. Yields on UK government bonds subsequently shot up so fast that pension funds got into difficulties and the Bank of England had to intervene. The political pressure on Truss grew so great that she resigned after only 45 days in office. 

The new government headed by Rishi Sunak believes a balanced budgetary policy to be extremely important and for this reason we do not anticipate renewed turbulence on the interest rate markets in 2023. The government is at present reviewing government spending and the proposed tax cuts under Truss are being or will be reversed. The fact that greater equilibrium has been restored to the UK’s budgetary and monetary policies is reflected on the financial market. Yields have now reverted to the same levels as before the debacle of Truss’s mini-budget.




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