- The US economy stepped up the pace in Q2 2023, with GDP growing above-trend at +2.4% annualized, driven by soaring business investment. Q3 data continue to show positive signs, including a sharp rise in consumer sentiment and continued solid performance in the labor market. However, incentives for manufacturing plants could be offset by falling consumer credit and a softening business investment.
- The Eurozone's economic outlook is increasingly challenging, with indications of continued weak performance. Q2 growth is likely to have remained weak, and July's PMIs confirm a further slowdown in the second half of the year. In light of sticky core inflation, the ECB left the door open for one last hike in September to 4%, leading to tighter credit conditions and reduced investment demand. Weak external demand from major trading partners adds to the headwinds. Divergences among member countries are evident, with Germany lagging and Spain showing comparatively strong momentum, notably thanks to services and public investment.
- Germany's economic outlook is still gloomy, even though further recession was avoided – with GDP stagnating in Q2. Indicators signal weaknesses across all sectors, with manufacturing and services experiencing declines. Structural issues, such as high energy costs and worker shortages, are exacerbating the situation, leading to a potential economic downturn. Capital outflows suggest waning attractiveness as an investment destination, posing further challenges for the country's economy.
- France's economy muddles through prolonged stagnation despite a surprise boost to Q3 2023 growth. Although Q2 2023 GDP growth was strong at +0.5% q/q, it was entirely driven by a boost from net trade. Exports, in particular, were buoyed up by the shipment of a large cruise ship. But falling corporate credit demand indicates a challenging outlook for business investment in H2, hinting at a marked step down of GDP growth in Q3, which we expect at -0.1% q/q.
US and Eurozone growth is defying gravity
In focus – US and Eurozone growth is defying gravity
Public debt in advanced economies – enjoying inflation’s “snowball effect” while it lasts
What’s behind this counterintuitive effect? Countries saw their debt ratios declining, thanks to nominal effects, while higher rates only impacted flows (rollover debt). In Figure 2, we break down the yearly change in the debt-to-GDP ratio by components: the primary balance; the “snowball effect”, i.e. the difference between the effective nominal interest rate on debt and nominal GDP growth, and finally stock flows (one-off government spending or revenues that are not included in the fiscal balance, such as equity injections or the proceeds of asset sales). In 2021 and 2022, we find that high inflation boosted nominal GDP growth (i.e. improving the denominator) while interest payments remained contained, supporting the “snowball effect”. Most of the stock of debt was issued at a low, fixed rate and with a long duration (around eight years on average in the Eurozone and five years in the US). Moreover, high inflation also contributed to reducing primary balances though higher tax revenues, which are tied to nominal tax bases. In Germany, the snowball effect alone reduced the debt-to-GDP ratio by a cumulative -11.3pps in 2021-2022, while in the US the change was an eye-watering -23.5pps.
It is also worth noting that in Germany, stock flows have been large, pushing up the debt ratio, while in Italy they helped reduced it meaningfully. However, generally, primary deficits have remained large, weighing unfavorably on debt dynamics, particularly in France (-3.2% of GDP in 2022) and Italy (-3.6%).
Bank of England – joining the club of aggressive (late) rate hikes
First rate cuts in LatAm – what to expect?
As the US and Eurozone approach the end of their hiking cycles, an easing cycle is about to begin in Latin America. The first rate cuts are due this week, led by Chile and followed by Brazil next week. Their early start to the hiking cycle allowed Latin American countries to better withstand the turbulence of 2022, and to bring inflation under control earlier than many advanced economies. It also led to strong performance for Latin American bonds and equities, with all except Colombia recording double-digit price returns and out-performing the MSCI EM benchmark so far in 2023. The top three best-performing currencies against the USD this year are also from Latin American countries(COP: +23%, MXN: +16%, BRL: 12%).
That said, we are entering a new phase of the cycle with very striking features. First, central banks in advanced economies are either continuing with interest rate hikes or pausing them. This means that, at least for the next two or three quarters, nominal rate differentials between central banks in Latin America and advanced economies should narrow.. Second, the inflation differential is well below the historical average (Figure 7). We expect this to remain the case or even widen in the coming year as inflation in major Latin American countries is expected to be lower than it has been in past decades (Figure 8) while inflation convergence in advanced economies will happen quite gradually.
In focus – US and Eurozone growth is defying gravity
After soaring in Q2, US growth momentum should soften in Q3. US GDP growth soared to an above-trend rate of +2.4% q/q annualized in Q2 2023 (+0.6% non-annualized), after an already strong +2% recorded in Q1. While household consumption softened as expected at +1.6% (from an elevated pace in Q1), the strength of business investment was a surprise, growing by +7.7%, its fastest pace since Q1 2022. Conversely, residential investment was weaker than expected: While housing starts data hinted at the beginning of a rebound, residential investment slipped -15.8%. It is now -23% off the peak reached in Q1 2021. Exports and imports were also weak, slumping -11% and -7.8%, respectively. However, as imports fell more than exports, the contribution of trade to GDP growth was positive. US export volumes are now back to below pre-pandemic levels.
Economic momentum seems to be holding up well at the beginning of Q3, although at much more moderate pace. Consumer sentiment picked up sharply in July (both current conditions and expectations) in the University of Michigan survey, while weekly credit-card data point to consumer spending growing at a decent pace. Meanwhile, the labor market continues to be solid, with lower initial jobless claims reported for the three first weeks of July. The industrial sector remains the weak spot of the economy, although timely data for July point to the sector bottoming out as industrial rail volumes, container exports and trucking demand have recovered from their lows. However, we remain cautious on the Q3 outlook: Weekly bank data point to consumer credit starting to fall in July, after growing robustly post-pandemic. We also expect business investment to soften notably, dragged down by falling office investment (office vacancy rates have continued to increase sharply) and oil & gas investment (as hinted by guidance from energy companies). Strong spending in manufacturing plants, incentivized by the CHIPS Act and the Inflation Reduction Act, should at least partially offset these headwinds. Overall, we forecast below-trend but decent GDP growth of +1.3% in Q3 (+0.3% non-annualized).
In Germany, the deindustrialization debate is in full swing. Structural issues have been pending for some time and are becoming more and more apparent, including a toxic cocktail of high energy costs, worker shortages and reams of red tape. Direct investment flows signal that capital is increasingly flowing out of Germany – a warning sign that the location is becoming less attractive. Unless there is an unforeseen reversal, it is difficult to escape the conclusion that Germany is on a path towards a more severe economic downturn, which could have far-reaching implications for the Eurozone as a whole.
France saw an upside surprise to Q3 2023 growth but underlying domestic demand is muted. France’s Q2 2023 GDP grew by a strong above-consensus +0.5% q/q. However, the solid outturn was entirely driven by a very large positive contribution of net trade, with exports soaring +2.6%, their fastest pace of increase since Q1 2022. This was partly driven by the shipment of a large cruise ship. Meanwhile, France’s ramp up of nuclear production boosted industrial production. However, domestic demand slipped -0.1% q/q – the third consecutive quarterly decline. Household consumption dropped a sizeable -0.4% q/q, weighed down by another sharp fall in food consumption. Total investment gained a lackluster +0.1%. Households’ investment in construction slumped for the fourth consecutive quarter and is now -6.2% off the cyclical high reached in Q3 2021.
The outlook for Q3 2023 looks challenging for France. The one-off boosts to industrial production and manufacturing exports are unlikely to be repeated. The July flash PMIs point to deterioration in both manufacturing and services activity. More telling, tighter credit standards reported in the ECB’s Bank Lending Survey (BLS) are yet to filter through to lower business credit growth, though credit lines to fund operating cash to corporates have already been drying up (-0.1% y/y in May). The BLS survey also points to a fall in credit demand to fund corporate investment amid high interest rates (Figure 15). Meanwhile, the government announced a +10% hike of the retail electricity price in August, while it had previously committed to refrain from further hikes after the February +15% bills increase. This is weighing on consumer sentiment, which remains depressed, and supports our expectation that consumer spending will recover only moderately in Q3. We expect GDP to slip by -0.1% in Q3, weighed down by weak investment and a negative payback in exports after the strong Q2 one-off performance.
Italy’s resilience is being tested. We do not expect Italy’s activity to have maintained the solid pace recorded in first quarter of the year (+0.6% q/q), with only a marginal increase likely for the preliminary GDP growth estimate for Q2, to be reported on July 31st. The latest manufacturing and consumer confidence surveys continue to show signs of deterioration. Manufacturing activity marginally increased in May after four consecutive months of decline but the short-term outlook remains gloomy. Credit growth is declining at a rapid pace as households and firms are facing skyrocketing interest rates. On the other hand, labor market conditions remain favorable and unemployment stood at a historically low 7.6% in May. Hence, we could see an upside surprise still from the consumer related services, to offset the – so far- slow implementation of NGEU funds that could play a role in the coming quarters.
Spain, in contrast, is keeping up good momentum. Q2 GDP data showed that the Spanish economy grew by +0.4% q/q after +0.5% in Q1, slightly above our expectations (+0.3%). The breakdown shows an important contribution from domestic demand, supported by the recovery in private consumption (+1.1% vs. -1.6% in Q1), as well as investment, which registered a strong increase in the quarter (+4.6% vs. +1.7% in Q1). It should be noted that external demand, particularly important for growth earlier in the year, lost momentum, with exports falling to -4.1% from +5.6% in Q1, suggesting an adjustment in the contribution of tourism, which was not enough to offset the slowdown in goods exports.
Over our forecast horizon, we expect the growth rate to be around +0.3% q/q over the next three quarters. We expect a continued (although smaller) positive contribution from net exports while domestic demand should keep its contribution to economic growth relatively modest. In particular, we expect some recovery in private consumption going forward, thanks to a robust labor market (Figure 16) and improvements in real incomes resulting from the rapid decline in inflation (3.8% in 2023 and 3.1% in 2024) and expected wage increases (4.6% in 2023 and 4.1% in 2024). Investments are supported by the NGEU funds, but we see a lot of uncertainty in their short-term impact due to the current political uncertainty stemming from the undefined results of the general elections, in addition to the established bureaucratic delays. Considering today's Q2 data, Spain's growth would be +2.2% y/y in 2023 (we would therefore revise our forecasts upwards from +2%).
Allianz SE Branch Rome