T. Rowe Price's Chief European Economist, Tomasz Wieladek looks at why Europe must tread a fine line to avoid stagnation
Key Insights
- Europe looks set for a mild recession in 2024 before returning to growth, but tight financing conditions and geopolitical uncertainty could hamper the recovery.
- The key risk is a return to pre‑pandemic‑era stagnation, and the European Central Bank will need to calibrate policy very carefully to prevent this from occurring.
- An earlier‑than‑expected rate‑cutting cycle would favour bunds and would likely weaken the euro against other currencies.
Europe very likely faces several quarters of negative, or at least stagnating, growth in 2024. How long this period lasts will depend on several factors, but the most likely scenario is that the eurozone undergoes a mild to medium‑sized recession before returning to growth toward the end of next year. However, the risk of a more prolonged period of stagnation cannot be ruled out, particularly if the European Central Bank's (ECB's) monetary policy remains too tight for too long.
A faster‑than‑expected drop in inflation would likely prompt the ECB to cut rates sooner rather than later. This would favour German bunds but would weaken the euro. European stocks are likely to remain muted until the recovery begins, at which point cheap valuations may provide a buying opportunity.
Demographics pose challenge for eurozone's biggest economies
Recent Purchasing Managers' Index (PMI) surveys indicate that the European economy is already in recession. German manufacturing data are very weak, and French manufacturing PMIs have been falling to a similar level. Manufacturing PMIs in Italy and Spain have improved a little, but from very low levels. Services PMIs are weakening across the whole of the eurozone. Overall, these dynamics suggest that the currency bloc is close to the bottom of its manufacturing cycle but the deterioration in the services sector could have further to run (Figure 1).
The deterioration in services likely has further to run
(Fig. 1) The manufacturing cycle may already be close to the bottom
As of October 31, 2023. Source: S&P Global. See Additional Disclosure.
Germany, Europe's manufacturing motor, faces multiple challenges. In the 2000s, social benefit reforms significantly raised workforce participation rates among middle‑aged Germans, keeping wage levels competitive. European Union accession countries provided a further source of skilled and competitively priced labour, while Russia supplied cheap energy and Chinese just‑in‑time inputs allowed Germany to focus on higher value‑added manufacturing.
Since then, many of these tailwinds have turned into headwinds. Social benefits cannot be reformed much further, and there are fewer economic migrants. Germany needs approximately 400,000 immigrants each year to plug the gap in its workforce left by an aging population but is struggling to attract them. The economy is being slowly weaned off Russian gas, and some strategic supply chains are being reconfigured. These structural changes will keep growth in Germany subdued for several years while it transitions to a new economic model. In the past, fiscal policy would have been deployed to ease the pain during this process, but Germany's debt brake rule means this is not feasible this time.
Italy will experience similar challenges to Germany on the manufacturing side, and, given its very high debt levels, the government is similarly constrained in its use of fiscal policy. France has an active industrial and fiscal policy, which will help to cushion the transition. France is the only large country in the eurozone with sustainable demographics, which means that it should be much less affected by population aging. Spain's economy has a much smaller share of manufacturing than the other countries. It could still be affected by a eurozone‑wide services downturn, yet surveys indicate that the Spanish economy continues to be by far the most resilient.
This post was funded by T. Rowe Price
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