The eurozone has brought down inflation faster than either the United States or Britain, and the scope for early interest rate cuts is correspondingly greater. Unemployment levels are low and wages have been rising. It should be a golden scenario, yet there are growing worries that Europe is heading into recession, with the powerhouse of Germany leading the way in the wrong direction.
The European Central Bank (ECB) is more cumbersome than its Western rivals, having more disparate national economies to balance, and was slower to raise interest rates. But that has not stopped eurozone inflation dropping to 2.4%, just above the 2% target rate, compared with over 10% towards the end of last year.
The ECB’s interest rate has been set at 4% and, all things being equal, that is likely to be a peak, although rates will come down very slowly. One of the most hawkish members of the ECB, Isabel Schnabel, has described the drop in European inflation as “remarkable” and added that there is no need for further interest rate rises. That has prompted optimists to forecast a fall in European interest rates in spring, although a quarter-point reduction to 3.75% by the end of 2024 is the best that most economists are expecting.
At the same time, various economies have stalled. Eurozone GDP contracted 0.1% in the third quarter and all the signs are that the figure for the fourth quarter will be worse. On the widely accepted basis that two quarters of decline constitute a recession, that means Europe will indeed have entered recession.
The rise in interest rates is feeding through into European economies, with less lending to companies and households alike.
The key leading economic indicator is the purchasing managers index, which in November was 47.6 for the eurozone, with any figure below 50 indicating contraction. A widespread deterioration in economic conditions was reported, with falling demand in goods and services, a decline in new orders and a steep fall in output from manufacturers.
It gets worse. Output is falling in the zone’s four biggest economies – Germany, France, Italy and Spain.
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Germany is the biggest worry, as its Constitutional Court is powerful and independent. The court has ruled that the federal government cannot transfer an unused €60 billion set aside to cope with the pandemic to finance a climate change fund.
This ruling goes well beyond the immediate implications because it reinforces the strong anti-inflationary constitution that has prevailed since the Second World War. The generation that lived through hyperinflation in the 1920s may have died out, but the fear has passed on to subsequent generations.
Germany has strict limits on how much debt the government can run up and there is probably a €105 billion black hole in the federal coffers running over the next four years. The court ruling implies that various devices to run up debt that has been kept artificially off the budget, are also illegal. Only last year €45 billion was spent off-budget on energy subsidies for households and businesses.
While the specific court ruling involves only the equivalent of 1.5% of GDP spread over four years, the wider implications are more serious. The court ruling severely reduces the scope that the German Federal Government has for financial flexibility within the constraints of meeting EU climate goals. The ruling will also have an impact on the country’s 16 state governments, which ran up funds during the pandemic and have since been using those reserves for other purposes.
German Chancellor Olaf Scholz is attempting to override the legal limit on public borrowing, but there are three parties in the government coalition and they are struggling to agree to a spending plan.
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Tightening government spending, which now looks inevitable, will have a heavy impact on the German economy, which was already hovering close to a recession. Economists had been expecting only sluggish growth for Germany in 2024, probably less than half a per cent. Now there are fears that Germany will stagnate, helping to drag the European Union, which has relied heavily on the German economy to fuel growth across the continent, into longer-term recession.
The eurozone has other issues to worry about as well. A spread of the conflicts in the Middle East, so far concentrated mainly in Gaza and Yemen, would see oil prices rising sharply and creating further inflation and putting a damper on economic growth.
Optimists hope for EU countries to average 1.4% economic growth in the coming year, but that will be scaled back if any issues with inflation reemerge. Most, if not all, European countries are in a weaker fiscal position than they were before Covid-19 struck.
Extra caution is clearly needed in selecting European stocks to invest in. It is unlikely that 2024 will offer chances to get rich quickly, so look for solid companies that are coming through the period of high interest rates with steady profits, preferably ones with low or no debts. Look also for companies with international markets that will be less dependent on how well the eurozone performs.
Rodney Hobson is a freelance contributor and not a direct employee of interactive investor.
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