European economic outlook: heading into winter on thin ice

Our baseline forecast of stagnating economic growth in Europe is playing out, with leading indicators such as PMI surveys affirming weakness ahead. As such, our euro area forecasts presented in last quarter's June update remain valid. Market consensus growth estimates are also converging towards our relatively more pessimistic outlook. Still, there are large divergences across countries, from Germany effectively in contraction versus other stronger western European economies. Despite our upward revision to UK 2023 GDP after a stronger-than-expected Q2 print, our medium-term outlook of stagnation is unchanged there too as tighter monetary policy increasingly takes effect. This, alongside last week's weaker UK CPI inflation report, explains the BoE's latest pause. The further 25bp BoE hike we forecast before YE2023 is now looking less likely. 

Key Europe economic forecasts

After September's ECB 25bp rate hike to 4.5% and the BoE's decision to keep interest rates at 5.25%, we believe central banks are summiting their rate hiking cycles as inflation slows and they wait for evidence of loosening labour markets. Now that rate hikes are behind them, the challenge for central bankers in Q4 2023 is to prevent too many rate cuts being priced in too soon (see Figure 1) due to falling inflation and slowing growth. To this end, we expect central bank communication to emphasise holding rates in restrictive territory until the decline in inflation proves sustainable. This is especially true after the 25% jump in the Brent crude oil price since June, which creates risks of higher and stickier inflation versus our forecasts in 2023.

Figure 1. The implied path of the ECB refi interest rate, 2024 and 2025 

We expect an increasingly coordinated growth slowdown among the euro area's economies as the lagged impact of restrictive monetary policy takes gradual effect. We expect a deceleration in the services sector (see Figure 2) in the coming months as wage growth continues to increase costs and the summer tourism boost ends. This will particularly affect the major services-led economies, such as Spain, which have so far seen relatively much higher growth this year. We see a gradual convergence with the growth outlook for industrial economies (such as Germany), which risk entering recessions this winter as elevated input costs and weak global demand continue to depress the manufacturing sector. These economies are particularly vulnerable to any further growth slowdown in China, though credit began to expand there again in August.

Figure 2. Euro area PMIs

We expect further weakness in Europe's real estate sector as the lagged impact of monetary policy accelerates into year-end. Real estate investment and construction will likely remain depressed in Q4 2023 as high financing costs, still-elevated construction costs and personnel shortages persist. For example, Germany has already seen a >35% decline in building permits for new buildings in 1H 2023.[1] Furthermore, high mortgage rates could further weigh on house prices (already down >12% in Sweden y-o-y) (see Figure 3), in turn discouraging private consumption via wealth effects. Lower affordability of home ownership and immigration is likely to keep demand in the rental market high.

Figure 3. Euro area House Price Index