Transcript
Speaker: Welcome to HSBC Global Viewpoint, the podcast series that brings together business leaders and industry experts to explore the latest global insights, trends, and opportunities.
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Speaker: Thanks for listening.
Speaker: And now onto today's show.
Speaker: The following podcast was recorded on the 19th of October 2023 by HSBC Global Research.
Speaker: All the disclosures and disclaimers associated with it must be viewed on the link attached to your media player.
Speaker: Remember, you can follow this weekly podcast on Apple and Spotify, or wherever you get your podcasts, by searching for The Macro Brief.
Speaker: Hello, I'm Piers Butler and welcome to the Macrobrief.
Speaker: This week we're focusing on the outlook for the European economy.
Speaker: Both the ECB and the Bank of England have raised interest rates sharply through the course of the year in an attempt to bring soaring inflation under control.
Speaker: Are the plans working or will more pain be needed?
Speaker: To discuss that and more, I'm joined by Simon Wells, Chief European Economist.
Speaker: Simon, welcome.
Speaker: Hi.
Speaker: So Simon, you recently presented at our Global Investment Seminar in London and I was in the audience and I have to say you were responsible for sending a cold shiver down my spine.
Speaker: Sorry about that.
Speaker: Well, the reason for that is that you took us back to 1989, which is etched in my memory because I was unfortunate to have a variable rate mortgage.
Speaker: And to your point, that was real pain compared to what we're experiencing now.
Speaker: That's right.
Speaker: In October of 1989, the then UK finance minister, John Major, famously said that inflation had to go and if policy wasn't hurting, it wasn't working.
Speaker: And at that point, UK policy rates had just hit 14.88%.
Speaker: So yes, I can imagine you were feeling the pain.
Speaker: The point being, though, that UK inflation didn't fall until the second quarter of 1992, and the economy didn't return to growth after a long recession until the third quarter of 1993.
Speaker: So the point is that at the point John Major had started talking about pain, there was over two and a half years more of pain before inflation finally came down.
Speaker: But today is different, and one wonders whether that level of pain is going to be necessary.
Speaker: After all, you've just published your latest Eurozone inflation briefing, and that highlights that inflation fell sharply in September, and you expect another big fall in October.
Speaker: That's right.
Speaker: But there's really two things going on in inflation.
Speaker: The first is the impact of last year's big energy price rises dropping out.
Speaker: So October really was the peak of energy prices last year.
Speaker: Now that's dropping out, we're seeing some very sharp falls in the annual rate of inflation, known as base effects.
Speaker: So yes, but I think September and October really will be the biggest falls.
Speaker: After that, we're looking more at service sector inflation.
Speaker: That's stickier, that's higher and not coming down.
Speaker: And of course, part of the reason it's not coming down is because wage growth is quite high.
Speaker: And if you're a service sector firm, well, I don't know, two thirds of your cost base is labour costs.
Speaker: You're going to have to pass some of that on.
Speaker: And so inflation in an underlying sense is taking longer to come back down.
Speaker: Is that why long term yields are still grinding higher?
Speaker: I think it's related.
Speaker: Again, there's a few things going on.
Speaker: But the first is the central banks have been telling us for some time that once rates reach their peak, which we think they have, they're going to stay at those levels for a long period, precisely because of what I was just saying about that stickiness of inflation.
Speaker: I think a few months back, markets thought perhaps interest rate cuts both in Europe and the US were going to come quicker than the central banks were saying.
Speaker: And now they're pushing out those expectations for rate cuts.
Speaker: And that's pushing up longer term yields.
Speaker: Another factor, of course, which is fiscal policy, is that past episodes of bringing down inflation have often been accompanied by fiscal tightness.
Speaker: And that is not what we're seeing at the moment.
Speaker: If anything, in Europe, we're still seeing a relatively loose fiscal policy.
Speaker: So the debate really at the moment revolves around what are the central banks likely to do?
Speaker: Are they going to stay at the current high levels or is there a risk that they go higher?
Speaker: Well, we're sort of taking the central banks at their word.
Speaker: And against the backdrop of the economics, it does look like rates have to stay where they are for some time.
Speaker: So our central case is that the ECB doesn't cut until December of 2024.
Speaker: By that point, it should have some forecasts out to 2027 and inflation should have come down.
Speaker: So it should have the confidence to do so.
Speaker: But in the near term, there is, of course, a risk that they have to raise again, depending on the incoming data.
Speaker: And going back to that conversation of pain that we started with, policy rates in this cycle would peak a lot lower than they did in the late 80s and early 90s, despite, if anything, inflation being higher.
Speaker: So the ECB meets on the 26th of October.
Speaker: What are we expecting?
Speaker: And if we're not expecting a lot of action on rates, is there any other actions that are likely to take?
Speaker: Well, good question.
Speaker: I think rates, it would be a big surprise if they changed rates.
Speaker: I think most of the ECB's governing council now seem in a mindset to talk about
Speaker: the duration of where rates are rather than necessarily the peak.
Speaker: But you're right in that the conversation may start shifting to other areas of policy, notably balance sheet policy.
Speaker: So at the moment the ECB is still reinvesting the proceeds of maturing assets that it bought under its pandemic emergency facilities and it may decide it wants to stop that reinvestment early.
Speaker: or it may discuss more fundamental framework changes to the way it implements monetary policy.
Speaker: But whilst that discussion starts in October, the ECB is conducting a review and we probably won't see any major changes until that review reports back, which should be towards the end of Q1 next year.
Speaker: As they're doing that review, is Italy on their minds?
Speaker: Well, Italy will certainly be on their minds, of course, because the bond spread has widened out quite a lot.
Speaker: And in absolute terms, the level of borrowing costs for Italy has risen to pretty high levels, almost 5%.
Speaker: So, yes, they're always worried about fragmentation across areas of the eurozone.
Speaker: And going back to that reinvestment policy, the pandemic emergency purchase programme, the reinvestment from that can be skewed in a flexible way.
Speaker: It's their first line of defence against spread widening in a particular country.
Speaker: So yes, to do away with that earlier potentially removes their first line of defence and a key tool in maintaining the monetary transmission mechanism across Europe.
Speaker: So yes, they will be worried.
Speaker: Let's turn to the UK.
Speaker: What, if any, room does the UK government have to cut taxes ahead of an election?
Speaker: Well, not a lot because, of course, UK debt ramped up through the financial crisis.
Speaker: It then ramped up again through COVID.
Speaker: So we're looking at a debt ratio of almost 100% of GDP.
Speaker: That's fine when interest rates are zero and negative in real terms, but now they're not.
Speaker: And so the UK's debt servicing costs will increase.
Speaker: well exceed £100 billion this fiscal year, I expect, putting it to be like the third biggest line of public sector expenditure after the NHS and state pension.
Speaker: So there isn't much more room to borrow.
Speaker: So that means any tax cuts would have to be funded with expenditure cuts, which obviously is very difficult politically ahead of an election.
Speaker: So I think any changes in UK fiscal policy are likely, in all honesty, to be fairly modest.
Speaker: Now, I don't like finishing on a negative note, but do we have to accept, putting all of this together, that there is a risk of much more pain ahead or even delayed pain?
Speaker: I think there is a risk of both of those.
Speaker: As I said, it would be very unusual to get inflation back from double digits sustainably to target with what's still fairly historically low level of policy rates.
Speaker: But we have to look at the positives, which are the labour market has been remarkably strong.
Speaker: We are past the worst in terms of the inflationary squeeze on incomes.
Speaker: So wage growth is now outpacing the rate of inflation, comfortably so in the UK.
Speaker: So from a consumer's point of view, regarding their incomes, we might be past the worst.
Speaker: And once their incomes start to build in real terms, they have more spending power.
Speaker: So we might just get inflation back
Speaker: without recession or a large rise in unemployment.
Speaker: Simon, thank you for ending on a positive note and thank you for joining us today.
Speaker: Thank you.
Speaker: Let's wrap up the podcast with a few highlights from the rest of the global research team.
Speaker: China has published its GDP data for the third quarter, and it exceeded expectations, accelerating to 1.3% quarter-on-quarter or 4.9% year-on-year.
Speaker: The consumption-led recovery continued to broaden out.
Speaker: Manufacturing activity picked up, but property investment showed a deeper contraction.
Speaker: Our China economics team expects the focus to turn towards longer-term structural growth as the recovery steadies.
Speaker: Our metals and mining team has just published our latest metals quarterly.
Speaker: And that weakness in China's property market remains a concern, along with global economic uncertainty.
Speaker: Despite this, most metals prices have corrected, and our team think any supply shock or demand recovery could pose upside risks to spot prices.
Speaker: And finally, our Industrials team have updated their proprietary HSBC Global CapEx monitor.
Speaker: 2023 has been another strong year of global capital expenditure growth at just under 9%.
Speaker: But Sean McLaughlin and Jonathan Day see that slowing next year to below 2%.
Speaker: Pockets of strength include software, airlines and electricity, with building materials and construction the weakest.
Speaker: If you'd like to know more about that or any of the reports, please email askresearch at hsbc.com.
Speaker: So that's all from us.
Speaker: Don't forget to follow the podcast on Apple and Spotify or wherever you get your podcasts by searching for The Macro Brief.
Speaker: Thanks very much for listening.
Speaker: We'll be back next week.
Speaker: Thank you for joining us at HSBC Global Viewpoint.
Speaker: We hope you enjoyed the discussion.
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