Spring 2024: Baltic and Global Economic Outlook

Baltic states have gone through a period of adjustment to several adverse events. The GDP growth rate was in 2023 below potential in all countries. Both Latvian and Lithuanian economy declined by 0.3% in 2023, Estonian economy contracted by 3.1%.
 
Low growth was caused by several factors. Baltic countries suffered from very high inflation rates in 2021 and 2022. This lead to a fall in real wages. Deposits lost about a quarter of the purchasing power. High interest rates have taken tall on the economies because almost all mortgages are with floating interest rates. Continuous implementation of Russian sanctions is reducing transit and companies are not able to benefit from previously cheaper Russian timber and metal prices for exports. Estonian growth has been weaker because of higher private debt level, stronger dependency on start-up sector and stronger effect of Swedish real estate sector through lower exports.
 
Real estate markets were booming in Estonia and Lithuania in 2021 and 2022. Real estate price index has increased by 62.3% in Lithuania and 52.8% in Estonia between 2019 Q4 and 2023 Q3. This exceeded strongly wage growth reducing real estate purchasing power. In Latvia the real estate prices are 33.9% higher and the increase is consistent with the wage growth. Estonia witnessed the strongest appreciation of house prices relative to average wage growth in 2021 and 2022 and is currently going through a slow adjustment process as wages are increasing and house prices have been stable or falling in some segments. In Lithuania real estate prices continued to grow longer and the stabilization process has started later as the economic conditions have been better than in Estonia.
 
On the positive side exports of services has been on a strong growth path and are expected to grow further. European Union funds will boost domestic demand and purchasing power is increasing again. Governments in all countries are running budget deficits to support the economy and as the debt level is low, there is ample room for support. Government bond spreads have decreased and financing conditions are improving. With the expectations of lower euribor, Baltic consumers are also the first to benefit from them.
 
Economic grow in 2024 in Lithuania is expected to rise to 2%, Latvian growth up to 1.2%. Though Estonia will start to grow in the second half of the year, because of the base effects, GDP level will be 1% lower than in 2023. While Estonian and Latvian economies will face a stronger growth in 2025 of 3% and 3.3%, Lithuania continues with 1.8% growth.
 
Inflation levels have stabilized and are below the euro are levels in Latvia and Lithuania. In February, Latvian year-on-year inflation was 0.4% and 0.7% in Lithuania. At the same time Estonian inflation was 4.2% because of various administrative decisions, including the increase of the value added tax from 20% to 22%. Annual 2023 number look high because of the base effects from 2022. Baltic inflation rates are strongly affected by world energy and food prices and because of the previous high cost pass-through to prices, currently underlying inflation rates are below the euro are levels. Prices of goods are falling, but because of slow adjustment and increasing wages, prices of services are increasing.
 
Price level in 2024 will be 0,2% lower in Latvia and Lithuania and 3% higher in Estonia, mainly because of administrative causes. While Latvia and Estonia will see only modest inflation in 2025 of 0.7% and 1%, Lithuanian inflation level is expected to reach 3% because of planned administrative measures.
 
Employment levels have been stable throughout last years. Unemployment rate in 2023 in Estonia stood at 6.4%, 6.5% in Latvia and at 7.2% in Lithuania. Latvian unemployment rate is expected to go down to 6.3% in 2024 and to 5.7% in 2025 because of the steadily growing economy and demography. Lithuanian unemployment rate increases marginally to 7.2% in 2024, to comes back to 6.8% year later. Estonia got the highest number of Ukrainian refugees in the Baltic states in per capita terms. Inclusion of the refugees in the unemployment statistics has increased the rate during 2023. The underlying local unemployment rate increased only marginally. With the shrinking economy, some firms are reducing staff, but the effect remains limited also in 2024 and 2025.
 
Nominal wage growth was in double digits in all Baltic countries in 2023. Lithuanian wages increased by 12.2%, Latvian 11.9% and Estonian 11.4%. Estonian wage growth was supported by the increase in public sector wages in 2023, while private sector wage growth remained lower because of weak economic conditions. Latvian and Lithuanian wages levels are below Estonian levels and are expected to continue to converge supported by strong economic growth. Wage growth in Estonia in 2024 is expected to be 7%, 7.8% in Latvia and even 8.6% in Lithuania. Wage growth exceeding inflation level will carry over to 2025 with wage increases of 6.5% in Latvia and Lithuanian and 5% in Estonia.

Table. Baltic Economic Outlook. Main statistics

Commodity prices declined in the second half of 2023 and are lower than forecasted. The price of oil currently stands below 85 dollars per barrel and has remained below that level throughout the winter of 2023/24. The price level even went below 75 dollars per barrel temporarily.
 
Oil prices have stayed in the assumed range between 70 and 100 dollars per barrel, which seems to be a commonly shared target among OPEC+ countries, but also for the US. For the US the price is high enough for local production to be profitable, but also to go on with the green transition projects as the price level keeps alternative energy sources profitable. Australia is seeking to start using other natural resources for the green transition and move away from exporting oil.
 
The prices have been at the lower end because of lower demand and stronger supply. The demand was subdued by an exceptionally warm winter which meant the highest temperatures ever recorded in some parts of the world. Another contributor is small Chinese demand as the economy is not growing as expected and hoped. On the supply side, there have not been serious production disruptions during the last half a year.  Energy supply in general, but especially natural gas supply from the USA, has been exceptionally strong. The Israel-Gaza conflict has introduced new tensions, but they have not escalated.
 
Our outlook assumes that oil prices will remain around 80 dollars per barrel in the range from 65 to 95 dollars with stronger upside risks than downside risks. The oil price is likely to fall even further in 2025 with the point outlook of 70 dollars and the rage from 60 to 90 dollars per barrel. These low prices will be supported by weak Chinese growth, especially in the energy-consuming construction sector and a fast shift to electric cars that reduced the demand even further. Worldwide countries are working to become energy independent and therefore imported oil will play a smaller role in the future.
 
The price of natural gas in Europe has also fallen as demand has been low due to exceptionally warm winter and the availability of LNG gas shipped from the US and Middle East countries. Natural gas sells currently below 30 euros per MWh, ten times down from the crisis level in August 2022. There are upside risks related to the energy markets as Europe is far from being energy independent.
 
World food prices have dropped to the levels where they were in early 2021. There are some products that have remained rather expensive. FAO sugar price index increased from the level of 109 in 2021 to 145 as the average price during 2023. In January 2024, the price has dropped to 135 again. Price index of dairy products increased from 120 to 150 in 2022, but currently back at 119. The price index of cereal products has even declined from 131 to 120, while being in-between at 155.
 
While real food prices are somewhat above historic averages, the levels are reasonable given the geopolitical challenges and weather extremes. Food prices internationally will decrease somewhat in 2024 and 2025, which is good for the consumers, but not for the agricultural sector in the Baltic states.

GDP growth continues in the US. The year-on-year growth rate in 2023 Q4 was 3.2%, which is a very strong growth rate even for the United States. The GDP has continued on the pre-Covid trend, the level of output in 2024 could be even higher than was expected five years ago.  
 
The US economy has been resistant to the shocks during the last two years. The US learned an important lesson from the two energy crises in 1970s. Resource dependence on the outside world is dangerous and the country became energy independent by mid 1980s. This has saved them from a lot of hardship. Though high energy prices have redistribution effects as consumers face higher costs, energy producers gain higher profits, the money does not leave the country and restrict demand much less.
 
The likelihood of a 2024 recession increased in the second half of 2023. The number of jobs created was decreasing throughout 2023 and consumer spending dropped at some points in the second half of the year. The beginning of 2024 is however again optimistic. Jobs are again created at higher speed and the consumer demand remains robust. Confidence indicators, such as PMI, is also indicating stronger expansion.
 
Stock markets are doing well. Stock price indexes have reached new historic record levels. The boom is very much supported by the hopes of the artificial intelligence (AI) revolution. However, only a small number of stocks have seen strong price increases. The stock indexes for small and medium-sized companies are underperforming compared to the big top performers. The growth base has narrowed through time and is more and more related to the hopes of AI, with Nvidia stock as the prime example.
 
The outlook for the US economy remains positive. Approaching presidential elections are likely to keep economy in shape in 2024. Economic growth is expected to slow down from the current high levels, but this gives more confidence in the longer future. A very strong growth in 2024 is more likely to lead to an overheating economy that has higher risks in 2025. Though inflation has been decreasing in the US, inflation is more and more related to high domestic demand. This is making the Federal Reserve more cautious in their previous plans in cutting rates.
 
The outcome of the election will not likely determine the health of the US economy. Main effects of the elections will be felt outside. Global trade patterns will change if the US introduces high tariffs against Chinese products. European Union might need to reconsider state aid policies if US introduces subsidies for high tech and green tech firms, which might lead to expatriation of technology leaders into US.

Chinese economy has been weak. GDP growth rates after the lifting of Covid restrictions are disappointing. The Chinese government’s 5% annual growth rate was achieved in 2023, but with the help of catch-up growth potential left from the end of restrictions. IMF forecasts below target growth of 4.6% in 2024 and even 4,1% in 2025. There are four important reasons for lower growth for many years ahead. None of them are easy for the Chinese government to change. First is weak demography. The number of young people entering the labour market remains low in the decades ahead. Young people were the core of creating innovation and IT capacity. Second is end of process were people from rural areas moved to cities. Therefore productivity is not increasing any more because of purely compositional reasons. Third is the political conflict China has started with the US and the EU. It is not only that China has taken a rather ambiguous position about the Russian aggression in Ukraine, but equally the conflict about the status of Taiwan is getting denser. China is aggressively entering EU and US markets with subsidized products, creating trade tensions. Fourth, the volume of apartments for sale roughly corresponds to seven years of sales. Unsurprisingly, the volume of housing starts in 2023 was just 38% of the level in 2020. At the peak of the boom the direct and indirect contribution of housing market to the GDP was 25% or slightly above. De-risking has started and the inflow of investments into China by democratic West has decreased strongly. China is and will remain an important trade partner, but there is a limit to the ever-increasing share of Chinese goods in our consumer baskets. This is unfortunately increasing costs and prices for producers, leading to lower consumer welfare.

Economic growth potential is strong in India. The anecdotal evidence of Apple factories producing iPhones moving from China to India is supported by stylized macroeconomic facts. India is growing at 6.5% both in 2024 and 2025 coming lightly down from the 6.7% growth rate of 2023. With the demographics still helping, development level still low and decentralized democratic leadership, the potential remains very high. India’s GDP estimates are on the optimistic side, but so are China’s.
 
Brazilian economy has been strong, but in the coming years the growth rate is expected to decrease to levels below 2%, which clearly underperforming compared to the expectations. Sub-Saharan Africa is luckily gaining some momentum, though negative risks are continuously on the table. Red sea conflict shows how linked is the world. The Houthi grouping openly wants to hurt Israel and its allies by attacking ships on the sea, making the trip from Asia to Europe is 10 days longer, multiply the costs and create supply chain obstacles that reduce productivity.

European economic growth has disappointed in 2023 and the outlook for 2024 is not strong either. The euro area economy grew by 0.5% last year and is expected to grow by 0.9% this year. This is clearly under the growth potential of the region which is 1.5-2%.
 
Last years have changed the European growth narrative. Germany and Northen Europe had strong economic growth while the Southern Europe was lagging behind. This has turned upside down. Covid harmed countries that relied on tourism, such as Italy or Greece. Now the countries are regaining some of the economic power they had before. Their success might be short-lived, however, as structural drawbacks remain in place – overregulation, export specialization, education level.
 
Germany was importing cheap energy and other raw materials from Russia to produce cars and investment goods for China. The cheap energy is history and China is not growing as fast. In fact China is now exporting cars to the European Union, made with cheap Russian energy, which used to be the strong side of German car industry. The inflow of Chinese EV into the European market can lead to a longer freeze for such an important industry. German economy contracted by 0.3% in 2023 and is expected to grow only by 0.5 percent in 2024. With the expected growth rate of 1.6 percent for 2025, it means that German economy will remain below the potential GDP level for long time. Important for the Baltic states, but especially for Estonia, Swedish economy fell by 0.3% in 2023. Even if it is mainly due to weak real estate sector, this had made the life of exporting investment goods to Sweden hard.
 
European Central Bank has a difficult job. Headline inflation is low because of decreasing energy prices. Core inflation remains above the target. Producer prices have increased by 39.1 percent compared to December 2019, which is two times more than consumer prices that have increased by 18.6 percent. Wage growth remains at 4.5 percent, about 1.5 percentage points higher than consistent with the inflation target. Both are putting upside risks to inflation. ECB has increased main weekly loan interest rates to 4.5% in the fall 2023 with the promise of keeping the rates at that level for at least half a year.
 
The ECB is likely to keep interest rates on hold until the June meeting. If inflation remains below the target during these months, the headline annual number is also reaching 2%. It is hard for the ECB to claim that the threat of inflation is there even if there are signs of it. The most likely scenario is still that the 6 month euribor is likely to be around 2.75% by the end of the year and fall to 2% by the end of 2025.

The world outlook is subject to many risks. Although some positive surprises are possible, the likelihood of negative events is higher.
 
Weather is playing a pivotal role, affecting not only agriculture, but also energy prices and supply chains. This is making prices very volatile, leading to higher uncertainty and lower investments. Green transition can be disruptive because many of the objectives are hard to reach. There are not enough technical solutions to reach the goals. Brown energy investments are discouraged, but green energy is not yet offering the stability of supply that is necessary for smooth functioning of the economy. House renovation plans that are too ambitious can result in increasing prices with little effect on quantities if supply side is restricted.
 
Geopolitical risks remain. In addition to the problems in Ukraine, small violent groups across the world might feel encouraged to show their power. The de-risking and friend-shoring policies with China move more production to the US as the ultimate safe haven, leading to higher prices and lower consumer welfare. The conflicts can also diminish over time, leading to stronger confidence that supports economic growth.
 
The arrival of AI to masses has lead to a widespread hope that work will be done by machines. This has pushed up stock market prices. When the positive effects turn out limited, then this might lead to market reversals. However the potential of AI has not be utilized so far in many places, leading to higher productivity and output.