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The Macro Brief - Europe’s dovish turn?
1 Plays2 seconds ago
Simon Wells, Chief European Economist, assesses the region’s prospects going into the second half of the year and explains why we think rate rises are off the table.
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Transcript
Intro & European Economic Overview
00:00:07
Speaker
This is the Macro Brief from HSBC Global Investment Research, where we look at the issues driving financial markets across the world. I'm Peter Stegall in London, and on this week's episode, we're assessing Europe's economic prospects heading into the second half of the year.
00:00:21
Speaker
When will inflation peak? Are more ECB rate rises on the cards? And what role will fiscal policy play?
Inflation Trends & ECB Rate Predictions
00:00:28
Speaker
To provide the answers, I'm joined by Simon Wells, Chief European Economist. Hi Peter. Good to see you.
00:00:34
Speaker
So Simon, it's been a scorching few weeks for Europe with heatwaves across several countries. But what's the economic temperature as the second half of the year begins? Well, I think the first half was actually reasonably resilient.
00:00:46
Speaker
If you look at most of the leading indicators of business, sure, they fell. um You would expect that. But they didn't fall to deeply recessionary or depressed levels. And of course, now, since the peace deal, although there are many risks and a lot can go wrong, the oil price and oil futures curve has shifted down sharply.
00:01:08
Speaker
And that means inflation will probably significantly. and quite a bit lower than we were expecting when we did our forecast update in mid-May. So you've called your report the doves of peace and you argue that that change in the geoplatical environment also changes the outlook for the European Central Bank. So what do you expect and what do markets expect?
00:01:29
Speaker
and That's right. I think everything has to be heavily caveated on the fact that we're assuming here in the base case that energy follows the futures curve. And as I said before, a lot can go wrong.
00:01:40
Speaker
But if it does, the peak of inflation will probably about half a percentage point below where we previously thought, peaking at around 3.4, something like that around the turn of the year.
00:01:53
Speaker
Now, if the peak in inflation is lower, the risks of second round effects on wages and then prices are lower, and the indirect effects of energy through food prices and non-labour costs on services, things like that, that should be lower too.
00:02:10
Speaker
So this should give the central banks a bit more confident to be a bit more
Market Expectations & Inflation Risks
00:02:15
Speaker
dovish. So what I'm expecting is that by the time it gets to the sharp end of the next decisions, be that September or December,
00:02:23
Speaker
If energy has followed the futures curve, it will probably be projecting inflation to be sub-target. Now, given the lags in monetary policy, if you then hike rates back end of the year, it's not going to be until mid-2028 before that has peak effects. That's going to exaggerate any undershoot in inflation and and soften further the labour market. So when we get to the point, I think they may well choose not to do it. In other words, they could be the doves of peace.
00:02:52
Speaker
And do markets agree with you? Almost. The amount of tightening priced in has come down a
Trade Prospects & Fiscal Policy Shifts
00:02:58
Speaker
lot. I think you're still lurking at one quarter point rate hike from the ECB and the Bank of England again by the turn of the year.
00:03:06
Speaker
But I think if you look at the risks, um they are... firmly ah to the upside. As I say, inflation could not peak quite as low if the oil price rises back again. So if you think of that market path as a kind of mean of the possible outcomes, I think it's not inconsistent with what we're saying.
00:03:29
Speaker
So let's talk about trade. Traditionally, exports are a major strength for Germany, among others, obviously the Eurozone's largest economy. Is trade going to ride to the rescue for Europe again?
00:03:40
Speaker
No, it seems unlikely. If you look at the indicators of export orders, it doesn't look like trade is going to turn around soon. So unfortunately, that means Europe has missed out on the big trade upswing that we've seen for some countries um led by ai In fact, if you look at Europe's export volumes, they're pretty much the same as they were six or even seven years ago. So there is, well, we know that Europe has a bit of a competitiveness problem, but right now it's really showing up in those trade figures.
00:04:15
Speaker
And when it comes to fiscal policy, which also plays a role in your analysis, you say the eurozone could be close to a turning point with an expansionary fiscal impulse this year set to become contractionary next year.
00:04:28
Speaker
So break it down for me. What does that mean and what could the consequences be? What it means is fiscal policy will stop acting as a tailwind to growth and start acting as a headwind to growth. I think that's another reason why the ECB, for example, may choose ultimately not to hike again. After all, on its projections, it's expecting a fiscal tightening of about 0.4% of GDP next year. We might not see anything as big as that, but um it's ah it's expecting something material in its forecasts. And what's causing that?
00:05:01
Speaker
Well, this year you've got German fiscal expansion ramping up, be that for defence or its infrastructure fund. But you've also got the tail end of the recovery and resilience facility money from the EU, boosting spending, particularly in Spain and Italy.
00:05:19
Speaker
Now that scheme is ending this year, but there won't be a massive cliff edge because, as we show in the report, actual spending is lagging the disbursements. So there's still money to hit the ground next
UK Economic Outlook & Challenges
00:05:29
Speaker
year. Nevertheless, it will wane, and that will mean, as far as kind of Italy and Spain and a few other countries are concerned, that will start to drag on fiscal policy and offset an ongoing but slow infrastructure stimulus from Germany.
00:05:46
Speaker
That's perhaps a good time to take a short break. We'll be back with more from Simon in a moment.
00:05:55
Speaker
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00:06:09
Speaker
Now, back to today's episode.
00:06:14
Speaker
So Simon, elsewhere in your report, you say the UK got off to a strong start in 2026, but the momentum seems to be fading. And that's now a familiar pattern. What's going on?
00:06:25
Speaker
Well, a cynic would say that the UK statistics office is having trouble seasonally adjusting data. And that could be a factor.
00:06:37
Speaker
On the other hand, there are genuine reasons, if we think back to 2024 or 2025, why this might happen. And often the word budget is associated with that. So uncertainty ahead of the budget, fear of tax rises, all seems to sort of weigh on activity in the third quarter, perhaps earlier, so that we get this pattern of starting the year with a boost of optimism and then concern about the domestic budget or some geopolitical event and shock that causes growth to slow as we move through the year. So I think some of it may be genuine economics.
00:07:16
Speaker
There may be a statistical factor as well. I don't know. um But we certainly think that that pattern um might be repeated again this year, given the very strong Q1 number.
00:07:28
Speaker
So what kind of growth are you looking for in the UK this year? It's very easy. It's 1% this year and it's 1% next year. Not exactly ah super strong, but you've got to see it in the background of the energy price rises. um and and And given that, it's no surprise with higher inflation that real-term spending power um will be reduced.
00:07:51
Speaker
And I think you've already hinted that you see the Bank of England on hold from here. But what are the key risks there? Well, it looks um to us like the UK labour market is quite a bit softer than in the eurozone. And some of the Bank of England the Monetary Policy Committee are certainly concerned about that. So if energy prices are down persistently, certainly it looks like Andrew Bailey is in no mood to tighten unless he absolutely has to. And so there may be a majority on the committee to keep things on hold. That being said, there's clearly at least two of them who are still very worried about a change in wage price dynamics, still worried about other supply headwinds and and inflation that's that's still in the pipeline. And in the yeah UK, unlike in the eurozone, of course, inflation never actually got back to fully back to target after the previous bout of inflation. And inflation expectations are a bit more elevated than they are in in the eurozone. So the risks are very much surrounding expectations of inflation and whether or not we see a change in wage behaviour as a result of that.
Structural Challenges & Regional Growth
00:09:04
Speaker
So overall then, you're arguing that Europe faces structural challenges which, if anything, may be getting worse. But if we were looking on the positive side, what are the relative bright spots in Europe today?
00:09:16
Speaker
That's right. I think the theme of the report is that we've had a degree of cyclical resilience, but structurally, there's there's seemingly less and less resilience. I think that mostly applies to Europe's largest economies. So I'm thinking Germany, maybe France and the in the UK. The bright spots are elsewhere. Spain, um we still see growing and relatively rapidly, as it has done over recent years. That's Still got a strong story behind it. You could say the same to a degree about Greece as and and maybe Portugal as well. And then, of course, there's Scandinavia, which is a relative bright spot for for growth.
00:09:53
Speaker
And also you've got a bit more optimism in the east as well. So Europe's a diverse place, but certainly it looks challenging for the for the larger economies. And periphery then for the bright spots? I think so.
00:10:06
Speaker
The sun's shining there.
Conclusion & Engagement
00:10:08
Speaker
Simon, thank you very much. Thank you.
00:10:17
Speaker
Simon Wells there on the Outlook for Europe. Before we go, a quick plug for our sister podcast, Under the Banyan Tree, where hosts Fred Newman and Harold van der Linde put Asia's economics and markets into context.
00:10:29
Speaker
And if you'd like to get in touch, please contact us at askresearch at hsbc.com. Today's episode was hosted by me, Peter Stegall, and produced by Tom Barton. Please like and subscribe to The Macrobrief wherever you get your podcasts.
00:10:42
Speaker
Thanks very much for listening. We'll be back next week.