18.09.2024.
The global economy has demonstrated strong resilience to numerous adverse shocks, but the overall growth remained modest compared to historical levels. Rising protectionism and intensifying trade wars act as a drag to global trade and threatens to turn upside down the decades-long tendency of freeing international trade. Rising geopolitical uncertainty, in turn, increases volatility of vital energy and other commodity prices as well as obstructs established trade routes, which further dampens global growth. Increasing rivalry and rising distrust between the two economic giants – the US and China – also encourages economic nationalism, which can be at odds with free market ideas. The rising role of governments and subsidy wars make small open economies relatively more vulnerable as global investors give preference to invest in larger economies, which lure them not only by offering bigger consumer markets, but also more generous subsidies. These developments may also increase global inequality at the expense of smaller emerging markets as global investors increasingly turn away from “offshoring” and give preference to “reshoring” or “friendshoring”. The EU, being more dependent on international trade compared to the US or China, is particularly vulnerable to these global developments. The weakness of the EU is exacerbated by its fragmented political decision making.
Demographics will also increasingly act as a drag for global economic growth. Over the last 50 years the global fertility rate declined from 4.3 to 2.2 and is now below the global replacement rate. It should be noted that the lowest fertility rates are reported not in the richest Western countries, but in East Asia (China, Japan, South Korea etc.), which will limit this region’s growth potential. Western countries habitually rely on immigration to mitigate natural population decline, but more populous ant less prosperous East Asian countries will have to find other ways to mitigate the negative effects of rapid population ageing e.g. artificial intelligence and robotization. Declining birth rates, however, is not necessarily bad news for our environment, especially given an accelerating global warming with the year 2024 being on track to become the warmest year on record.
An ongoing artificial intelligence and robotization revolution will boost productivity and increase global economic growth. Yet, it also increases global income and wealth inequality, since majority of leading high-tech companies are concentrated in the US, EU, China and other leading economies. The US is set to benefit the most from an ongoing technological revolution with the EU and China lagging behind. The US also benefits from being the global energy powerhouse: the US is the largest global oil producer, the largest natural gas exporter whereas Inflation Reduction Act boosted investments into green energy (primarily solar and wind). The USA also has more favorable demographics, compared to the EU and China. The US dominance is well illustrated looking at the latest stock price developments: the US stock market index is ~140% higher compared to 2019 levels, the EU’s – 70% higher, whereas Chinese is 10% lower. We believe that transatlantic economic divergence is set to continue with the US economy continue to outperform the EU, whereas transpacific convergence between China and the US will weaken with China unlikely to becoming the largest global economy any time soon.
The near-term global economic prospects are not as bright as was projected at the beginning of the year. Global economic surprise indices dipped into negative territory in mid-2024 and are underwater in all three largest economies (USA, EU and China) suggesting that global economy will have a bumpy ride ahead. The soft-landing of the USA economy is still the most probable scenario, but cooling labour market suggests that growth in 2025 will be weaker. Increasing protectionism and global trade disruptions will cause the global trade to GDP ratio to shrink further. This will affect the European Union, which is likely to continue living in a stagnation mode with Germany flirting with economic recession. China will find it challenging to keep growth up to its ambitious 5.0% target, while demographics, sluggish housing market and an ongoing decoupling from the West will continue weighting on economic growth. Monetary policy easing in the USA and the euro area as well as fiscal stimulus in China may not be sufficient to boost global economic activity, but it should mitigate downside risks and bring more stability to global economic growth. We forecast that the global economy has entered a slower and more fragmented growth phase and will continue growing at a moderate ~3.0% pace in 2024-2026.
The US economy performed exceptionally strongly during the last 5-year period of turbulent times, supported by cyclical as well as structural factors. Generous fiscal and monetary stimulus allowed the economy to rapidly recover from COVID-19 recession, while thriving high-tech and energy (both traditional and green) sectors boosted productivity, improved competitiveness and helped to mitigate global energy price shock caused by Russian military invasion in Ukraine (the US is the largest oil producer and the largest natural gas exporter in the world). The US economy has been growing faster than other major developed economies with growth remaining strong even after the Federal Reserve Board (FED) hiked interest rates. The US economy is now 11% larger compared to 2019 levels - impressive, given that German economy is only 1% larger, while Japanese, French and British economies are 2% larger. We expect US economic growth to slow down, but outright recession should be avoided, hence soft landing, rather than hard landing, scenario is still the baseline one.
The US labour market is gradually cooling – job openings are falling, employment growth is slowing down, wage growth is moderating and the unemployment rate is rising. The weakening labour market opens the door for interest rate cuts despite still somewhat elevated inflation, since the FED’s focus is increasingly shifting from price stability to maximum employment. Yet, we expect that interest rates will be lowered only gradually as the fundamentals of the USA, contrary to the euro area, remain strong and the FED will have to perform a balancing act to lower interest rates enough to avoid economic hard landing, but at the same time not too much to prevent economy from overheating. The so called Sahm rule suggests that when unemployment rate raises by half percentage point - recession usually follows (it increased from 3.4% in April 2023 to 4.2% in August 2024), but this time an upsurge in unemployment is caused not by shrinking employment, but rather increasing labour supply due to growing immigration. Under the baseline scenario, we assume that the FED will gradually lower rates from the current 5.5% to 4.0% by mid-2025. Yet, the uncertainty about the future path of interest rated remains high, which could increase volatility in stock, bond and foreign exchange markets - violent market moves, such as the ones observed in August 2024 could also not be excluded as investors may be switching between the risk-of and the risk-off sentiment. The key unknown is how households will react to dwindling pandemic-era excess savings, which supported household consumption and shielded them from high interest rates (household debt to GDP ratio has dropped to the levels last observed in 2001).
Increasingly polarized political landscape in the USA (as well as in many EU countries) raises economic and foreign policy uncertainty, which is set to culminate during the presidential and congressional elections to be held in November 2024. The upcoming US presidential elections will be of utmost importance – especially for the EU, given that D. Trump promises to impose 10% import tariffs on the EU exports as well as to limit US military and financial support for Ukraine. In addition, D. Trump openly urges the FED to lower interest rates, which may weaken US dollar against the euro thus making European exporters less competitive. The USA also plays a major role in safeguarding European energy security, since it became one of the major natural gas exporters to Europe following the Russian-European energy war. The fiscal policy uncertainty is also elevated as both US presidential candidates do not present a credible plan on how to lower US federal budget deficit, which has ballooned during the COVID-19 pandemics and remains at abnormal 7,5% of GDP (in the euro area it is forecasted to drop to 3.0% of GDP in 2024). Sizeable budget deficits and high public debt levels leave less fiscal room to finance extraordinary spending, which could be caused by rising geopolitical tensions as well as rising financing needs for green transition, digital revolution and ageing society.
China has been the major contributor to the global economic growth over the past few decades. Economic liberalization policies implemented in the late XX century as well as geopolitical rapprochement with the West woke up the sleeping Chinese dragon. In the 1980’s China was among the poorest countries in the world (it’s GDP per capita constituted a mere 8% of global average and was significantly lower than that of Africa), but few decades of exceptionally rapid growth transformed China into a real economic giant. China became the second largest economy in the world at market exchange rates, while GDP per capita approached global average. However, Chinese dragon is running out of fire: China’s growth averaged as much as 9.8% in 1990’s, 10,3% in the 2000’s and 7.6% in the 2010’s, but the growth is forecasted to slow down to a mere 4.0% in the 2020’s and 2.5% in the 2030’s. Increased geopolitical tensions, rising protectionism, rapidly ageing society, increasing indebtedness, housing market imbalances as well as lack of political liberalization slows down and will continue to slow down Chinese economic growth in the near future.
Draconian COVID-19 restrictions not only dampened domestic consumption, but also drastically reduced fertility rates, which fell from 1.5 in 2019 to 1.0 in 2023 – among the lowest in the world and substantially lower compared to the USA (1.7) and the EU (1.5). The number of children born in China fell from 18.8 million in 2016 to 9.0 in 2024, whereas continuous drop in the number of marriages suggests that birth rates will drop ever further. Hence, China’s population decline, which started in 2022, will accelerate in the coming years. Symbolically, China has lost the status of the most populous country in the world to India, which is increasingly being regarded as the Asian economy with most potential. Demographic challenges are worsening a prolonged slump in the housing market. The number of housing transactions and building permits continue to drop, while 95% of major Chinese cities report falling housing prices. Dormant housing market poses a real challenge for Chinese regional governments, which used to generate substantial share of their revenues from land sales. China is financing the widening gap between budget revenues and expenditures by running large budget deficits (~7.0% in 2024), which were virtually non-existent a decade ago.
The honeymoon between China and Western investors is coming to an end. Supply chain disruptions during the COVID-19 pandemics, escalating trade wars as well as China’s geopolitical decoupling from the West (and recoupling with Russia) encouraged international investors to diversify their exposure away from China. The “offshoring” is being increasingly replaced by “reshoring” or “friendshoring”. As a result, FDI’s to China have dropped almost to zero since 2022 and is unlikely to recover. Chinese companies are also increasing their investments abroad aimed at lowering their risks from escalating global trade wars and finding back door entrances to Western markets – Mexico, Vietnam, Hungary and Singapore are among the most favorite ones. Weak domestic demand encourages China to pursue export-driven growth, but it incites protectionism from the key export partners. The ES, EU and Canada recently introduced whooping import tariffs for Chinese electric cars and more countries can follow the suit. This will limit Chinese investment and exports going forward, which will act as a drag for overall economic growth. We forecast that China will struggle to reach its ambitious 5.0 growth target this year and in 2025-2026 growth will slow down towards 4.0%.
After a short-lived post-COVID recovery the euro area has entered economic stagnation: last year GDP grew by a mere 0.5%, while this year growth is forecasted to average 0.8% - well below the 2.2% average annual growth observed during the 2015-2019 period. It is widely anticipated that lower inflation and declining interest rates will reinvigorate growth in the euro area. Yet, we believe that these factors will not be sufficient to pull the euro area out of economic stagnation given the multitude of structural challenges faced by the euro area in general and Germany in particular. We believe that the euro area growth will remain weak both in 2025 and 2026 with GDP growth barely exceeding 1.0% mark.
The key reason for our gloominess is dismal German economic situation, which over the course of the last five years has transformed itself from the global industrial powerhouse back to the sick man of Europe. Germany is suffering from a multitude of negative external and internal negative shocks, which will last years if not decades into the future. At the forefront of German malaise rests its manufacturing sector, which leaped from Russian energy bear to Chinese industrial dragon. Russian-European energy war, which started in mid-2021, increased energy costs and made them less predictable for German manufacturing companies. Energy-intensive companies were particularly hard hit with production dropping 20% below 2019 levels. Another shock for German manufacturing sector came from rising Chinese competition – especially in motor vehicle production. German automotive companies were slow to transform from diesel/petrol driven cars to electric cars, which resulted in lost competitiveness vis-à-vis existing competitors from the USA, Japan and other EU countries as well as fast growing Chinese competitors. Motor vehicles production in Germany is falling and the trend is likely to continue – especially given the recent announcement by the largest German automotive producer “Volkswagen” about the plans to close some of the German plans. German demographics and conservative fiscal policy will also act as a drag to economic growth, hence Germany will continue to balance at the brink of recession in 2025 and possibly also in 2026. Multiple leading indicators support our view e.g. the IFO Business Climate index suggests that Germany is heading for yet another recession in end-2024.
To paraphrase the commonly known quote “when Germany sneezes, the whole Europe gets sick”. Yet, the rest of the euro area so far has been remarkably resilient with Southern European countries demonstrating particularly robust growth. For example, Spain is forecasted to generate close to 3.0% growth this year, while Germany will be in recession. However, one should keep in mind that Spanish economy enjoys a boost from post-COVID “revenge travelling” with record-high number of incoming tourists. This trend, however, is unlikely to continue next year, hence Spanish (as well as other Southern Europeans) economic growth will slow down in 2025. France and Italy are also suffering from shrinking manufacturing sector albeit stronger service sector performance helps these countries to stay afloat. Yet, the economic growth in these countries has been largely supported by exceptionally generous fiscal policies, which kept budget deficits at or close to record-high levels. Budget deficits in Italy and France stood at 7.4% and 5.5% respectively, which prompted the EU to initiate excessive deficit procedures against these countries (as well as 5 other EU countries). It will be a difficult, if not impossible, task to reduce budget deficits for these countries without causing a substantial economic slowdown or even an outright recession as revenue growth slows down (mainly due to lower inflation, but also weak growth) while appetite for budget spending remains high. France recently announced that budget deficit this year could rise to at least 5.6% i.e. higher than last year. Italy is reiterating its commitment to lower budget deficit to 3.0% by 2026, but it has little choice given that its debt to GDP ratio already stands at 137% of GDP – the second highest in the EU. In any case, three largest euro area economies - Germany, France and Italy – has very little space for any extra fiscal stimulus (Germany due to self-imposed constitutional limit and France and Itay – due to the Maastricht Treaty rules), which will limit potential euro area growth in the years ahead.
The euro area hopes on consumers, who are expected to increase spending as inflation and interest rates fall while wage growth remains robust. Lower interest rates should also reinvigorate the dormant housing market. Lending for house purchases rebounded in mid-2024 - growth for new housing loans accelerated to 29% y/y in euro area and 42% y/y in Germany, albeit from very low levels. Strong labor market continues to support consumption, but leading indicators suggest that the tide is gradually shifting and demand for labour is dwindling. Yet, euro area companies are reluctant to lay off employees fearful of fundamental labour shortages primarily caused by unfavorable demographics. Hence, the euro area labour market will be characterized by weak employment growth, but at the same time relatively low unemployment rate. As long as people will not be losing their jobs en masse, the risk that they will cut consumption is relatively limited. The biggest threat comes from Germany, which is losing high-paid manufacturing jobs, which are being replaced by lower-paid service or public sector jobs. If consumers start being fearful about their employment prospects, consumption recovery may not be as high as expected. Consumer confidence indicators suggest that consumption should continue to gradually recover in the second half of 2024, but longer-term prospects remain uncertain. This view is supported by the consumer confidence indicator, which was gradually trending higher in the first half of 2024, before plateauing in July and turning slightly south in August. Lower interest rates should also give boost to investments – especially into energy, defense and real estate sectors. Yet, investments into manufacturing will continue to be weak – especially in Germany.
Even though headline inflation in the euro area has dropped substantially since the peak levels reached in end-2022 (10.6%), it still remains somewhat higher (2.2% in August 2024) than the European Centra Bank’s (ECB) target of 2.0%. We forecast that inflation in the euro area will remain slightly above the 2.0% target both in 2024 and in 2025. The higher for longer inflation in the euro area is primarily caused by strong increase in prices of services as well as sticky prices of food products. Prices of services continue growing at 4.2% - three times faster compared to the average annual increase of 1.4% observed in 2015-2019. Growth in service prices is primarily driven by fast-rising wage costs, which are then passed on to end consumers. In Germany, the negotiated wages are expected to increase by 4.6% in 2024 – the fastest pace in the XXI century. Whereas in the euro area wages are expected to rise by 4.2% - only marginally lower compared to record-high increase in 2023 (5.1%) and substantially faster than 1.2-2.2% increases observed in 2010-2019. Employees continue to demand higher wages with the aim of regaining their purchasing power lost during the 2022-2023 inflationary shock. For example, food prices in the euro area are as much as 26% higher compared to 2021, while wages have increased by an estimated 15% (overall inflation increased by 18%). Tight labour markets and generous fiscal spending give employees strong negotiating power, hence wage growth is expected to remain strong. Recent data suggests that euro area (especially Germany) have fallen or are about to fall into the wage-price spiral with wages chasing ever increasing prices and prices, in turn, are rising as a response to fast rising wages.
Higher for longer inflation prevents the ECB from lowering interest rates faster, but we believe that weaker than expected economic growth figures (especially in Germany) may prompt the ECB to lower rates despite still elevated inflation. The ECB will also be compelled to follow the FED if the latter decides to lower interest rates faster - otherwise there would be a risk of sharp euro appreciation, which would further jeopardize euro area competitiveness and deepen an ongoing contraction in the euro area manufacturing sector. Under the baseline scenario, we assume that the ECB will continue to gradually lower interest rates, which should reach a more neutral level of 2.0% by mid-2025. Yet, the uncertainty about the future interest rate path is exceptionally high. The key risk is that euro area may not be able to bring down inflation without incurring an economic recession i.e. soft-landing scenario may be replaced by hard-landing scenario. Under the latter scenario, interest rates may stay higher for longer before abruptly dropping well below the 2.0% neutral mark. Interest rates may stay higher for longer if there will be further adverse energy and/or food price shocks – primarily from potentially increasing geopolitical tensions in the Middle East or Russia. Global trade disruptions and rising protectionism could also keep inflation elevated for longer. On the contrary, greater than expected energy and food price declines would increase the chances of a soft-landing scenario and may prompt the ECB to gradually lower rates despite still elevated wage growth.