Why we believe Europe is heading for recession

Consensus forecasts for European growth have been slashed in recent months, but we think there’s worse to come.

We’ve been warning about European recession risk since the spring and our fears appear to be materialising. Our base case is now a ‘normal-sized’ recession over the next year, with the euro area economy contracting by 1% in 2023 and the UK by ½%.

Energy shockwaves

The cumulative energy shock facing Europe due to Russian gas supply curbs appears worse than in the 1970s. Government support measures aimed at easing the pressure on household utility bills are welcome. But companies also face rocketing energy bills, so we’ll see a combination of higher core inflation and profit margins being squeezed.

Some energy-intensive industries routinely curtail production in the winter so energy can be diverted to heating households. These cuts are likely to be deeper and broader this year, particularly if governments are forced to ration energy. This would have knock-on effects through the supply chain. A shortage of semiconductors depressed auto production during COVID-19. A shortage of fertiliser, glass and steel would impact the agricultural, construction and other manufacturing industries too.

Drought is also posing a near-term threat to industry as low water levels restrict fuel transport from Rotterdam to Europe’s industrial heartland along the river Rhine.

A new credit crunch?

The threat of wage-price spirals has also led to tighter monetary conditions around the world. Corporate yields have surged and banks have begun restricting the availability of credit. This is how a self-reinforcing credit crunch typically begins. As banks make it harder to borrow, the economy weakens, which in turn leads to more problems for indebted businesses and households, leading to a further tightening of credit conditions.

This combination of surging energy prices, rising interest rates and tightening credit conditions has pushed our lead indicator for European growth deep into negative territory. A broader range of survey data has deteriorated. Initially it was consumer confidence and the German IFO expectations balance. But we’re now seeing the monthly PMI surveys signal contraction.

The relative weakness of European growth has manifested itself in a weaker euro and sterling exchange rate over the past year.

At an asset level, we expect further outperformance of European defensive stocks versus cyclicals. We’re also looking for bunds to outperform Treasuries and gilts.