Tuesday, March 28

Europe Outlook 2023: Is a recession really avoidable?



ON the back of macroeconomic data which has come through better than expected, the biggest drivers of the rally to date in the STOXX 600 can be attributed to the weakening of the USD, lower rate expectations and falling bond yields.

After posting one of the worst years in decades in 2022, equities and bonds had one of their best Januarys on record year-to-date, rallying more than 20 per cent from its lows in late September 2022, as it has become clear that Europe has managed to avoid the near term energy crisis this winter.

However, the rally is likely driven by investor sentiment rather than fundamental reasons, with systematic algorithms, trend-following investors buying back into equities, and hedge funds massively short-covering from an overly pessimistic positioning from last year.

Furthermore, with strong economic data coming from the US and Eurozone inflation numbers falling back to single digits, investors are increasingly hopeful of a potential soft landing. Combined with the expectation that central banks are heading towards the end of the monetary tightening cycle this year, investors have a renewed sense of optimism, resulting in a risk-on climate.

However, we argue that the markets may be overly optimistic, and the current rally is not sustainable. While high frequency indicators suggest that the Eurozone may defy the odds of potentially avoiding a recession, it is unlikely that the European economy will go unscathed from the delayed effects of the rapid ECB tightening, so there could be more downside risk ahead should Europe experience an economic contraction, especially after the recent rally.


STOXX 600 has rallied furiously ever since bottoming in late September 2022.

Growth outlook has improved from before but remains weak

With the recent release of GDP figures, Europe managed to narrowly avoid a fourth-quarter contraction projected in November 2022, on the back of a warmer-than-expected winter and a strong labour market.

Since the last economic projections, there have been favourable developments which have improved the growth outlook for 2023. The diversification of supply sources and a drastic drop in consumption has left gas storage levels above the seasonal average of past years, and wholesale gas prices have fallen well below pre-Ukraine war levels.

Furthermore, Europe’s labour market continues to remain strong, with unemployment rate coming in at 6.7 per cent for 2022, which is the lowest figure in the past few years, well below the 5-year and 10-year rolling average figures (Figure 2).

In addition, consumer confidence is slowing rebounding ever since bottoming in September 2022, but figures remain at secular lows even as conditions have improved in the short term.

However, looking at leading economic indicators such as the PMI, the data points towards a possible mild economic contraction. Although there has been a small uptick in the both manufacturing and services PMI, manufacturing PMI continues to be contractionary territory, dimming the near-term growth outlook.

Next, the tightening to date has begun to pass through to less supportive conditions for households. Higher borrowing costs have significantly increased the debt service costs of existing borrowers and made new mortgage borrowing less attractive and these have led to a decline in home prices.

As home prices fall, there will be a negative impact on household wealth, which can lead to a decrease in household spending and ultimately impact economic growth.

With the recent turn of events and rosier than expected macroeconomic backdrop, GDP forecasts for the Eurozone have been revised upwards on a quarterly basis. However, coming off a low base, these revisions are likely to be overly optimistic as Europe still faces longer-term issues, like the ongoing energy crisis which is structural in nature, and lagged effect of policy tightening which has yet to be reflected in consumer spending.

Even with the recent revisions to the upside, GDP in Europe is expected to expand by only 0.3 per cent in 2023 for the entire year, which lags behind that of US and Japan, making it the weakest developed market within our coverage.


Labour market continues to remain tight as unemployment rate trends down.

Euro area inflation remains elevated

Next, headwinds arising from rising prices continue to persist, which affects both consumers and businesses detrimentally.

Although the headline inflation in the Eurozone has been trending down towards single-digit territory from its peak of 10.6 per cent year-over-year back in October 2022, it is still currently running at multi-year highs.

Furthermore, core inflation (which excludes volatile items such as energy and food) has yet to peak and was still rising in January, which erodes the purchasing power of households.

Although the surge in European inflation was initially concentrated in energy and goods, the problem has become more broad-based. The more alarming issue is the pickup in nominal wages, on the back of tight labour markets. Higher incomes can cause a self-reinforcing cycle of spending, making it more difficult for the ECB to achieve its two per cent target inflation.

As these inflationary pressures persist, it would be difficult for the ECB to put the brakes on monetary tightening, at least until they see a meaningful deterioration in economic and labour market conditions, which will weigh on business activity and could cause a drag on investments.

Combined with the fact that the ECB is set to start quantitative tightening in March, which further lowers the availability of money circulating in the economy and drains liquidity away from the financial markets, these concerns look under-reflected in the relatively optimistic pricing of European equities.


Services PMI may have rebounded but Manufacturing PMI remains in contractionary territory.

Energy situation unlikely to be resolved soon

With the help of a milder than expected winter and targeted government policies to curb the use of natural gas, Europe has managed to escape the worst-case scenario of a severe energy crisis, with natural gas prices falling sharply from their previous peaks.

This has helped to partially diminish the effects from the rapid rise of headline inflation, and has provided some cushion to real spending.

However, the energy problem in Europe is structural, with a lack of sufficient and proper infrastructure to keep up with the demand of energy consumption in Europe.

Today, more than half of Europe’s energy consumption still comes from imported sources, leaving it vulnerable should there be any political or economic wars with other countries.

This issue has been brought to light during the Russia-Ukraine war, which has led to huge investments into renewable energy to accelerate the path to energy independence.

With that being said, the setting up of these supply chains and infrastructure upgrades require time, thus energy prices are set to continue remain elevated in the near to mid-term.

Furthermore, Russia has stated that they will cut oil output by about five per cent in March this year, after the West imposed price caps on Russian oil and oil products. This can exacerbate the supply side constraints for energy in Europe and keep energy prices higher for longer, further fuelling inflation concerns.


Earnings may be revised downwards

The fall in European equities in 2022 was due multiple compression on the back of rising real interest rates. Just as the expected recession has not arrived yet, neither has the anticipated sharp downgrade to corporate earnings.

In fact, earnings estimate for European equities have seen strong revisions to the upside in the past few weeks, as fear of an energy crisis subsides and better than expected macroeconomic data has buoyed investor sentiments.

However, consensus estimates of EPS growth and resilient margins may be too optimistic, as we have yet to fully grasp the delayed effects of the fastest pace of rate tightening in the ECB’s two-decade history. As it stands, current projections are pricing in a mild recession or soft landing with markets pricing in the end of the tightening cycle soon.

Nonetheless, a hot labour market does not offer much room for a policy U-turn just yet, especially when core inflation has not peaked yet.

Fortunately, if the unemployment rate does not spike, it is possible to avoid a negative spiral seen in many past recessions, where falling demand leads to falling employment, which further compounds falling demand. Therefore, even if Europe experiences a recession, the downturn might be shallower than most expect.

With European equities currently trading below its historical average P/E ratio, there is room for further upside.

However, the margin of safety is shrinking as P/E multiples have rebounded from its recent lows and is approaching its long-term average (Figure 9), leaving considerably less room for any disappointment moving forward.