Global Daily – Deeper eurozone recession raises spectre of deflation

by: Nick Kounis , Aline Schuiling , Bill Diviney

Euro Macro: Changes to our eurozone growth and inflation forecasts – We have lowered our outlook for growth and inflation in 2020 and 2021 in the eurozone. This has been motivated by a number of factors. In the first place, Eurostat’s flash estimate of GDP in Q1 (-3.8% qoq) was weaker than we had estimated originally, indicating that the impact of the lockdowns – that started in most countries around the middle of March – was bigger than we had thought. One caveat is that some large eurozone economies have not yet published a first estimate for Q1 GDP (Germany and the Netherlands will publish on Friday) and that national statistical offices have warned that the preliminary Q1 numbers are surrounded by a lot more uncertainty than normal and will probably be revised significantly at a later stage.

An additional factor that triggered the revision is that the lockdowns in various eurozone countries have been extended into the first weeks of May, whereas we had assumed that they would end at the time that was initially announced by the various governments, which was in the course of the second half of April in most cases. What is more, the easing of the lockdown measures that has been announced in most countries will be very gradual and step-by-step, which implies that the rebound in growth after the full lockdown will be weaker than we had assumed before.

Finally, the negative second round effect from lockdowns (higher unemployment, tighter financial conditions, corporate defaults, supply chain disruptions) are expected to be stronger because the lockdowns lasted longer. This will continue to weigh on growth in 2021. Although we still incorporate a sharp jump in GDP growth in Q3, we continue to forecast a double dip recession around the turn of next year. A durable recovery will not begin until Q2 2021. Overall, our annual GDP growth forecast for 2020 has been lowered to -6.9%, down from -4.3%. Due to the lower base in 2020, the annual growth rate in 2021 has risen, despite the fact that we have lowered the quarterly growth pattern. Annual growth in 2021 now is expected to be 3.2%, up from an earlier expected 1.6%. At the end of our forecasting horizon (2021Q4) we expect GDP to be more than 3% below its 2019Q4 level (was -1.7% in our previous forecasts) and to be around 6% below the trend-level.

This level of spare capacity will weigh heavily on inflation over the coming years. It will be reflected in a sharp rise in unemployment and a sharp fall in wage growth. In addition, inflation expectations have fallen further over the last few months, which will also depress both wage growth and inflation directly. An important judgement behind this view is that the demand shock hitting the economy is overshadowing the supply shock and this will remain the case despite aggressive monetary and fiscal stimulus. We expect core inflation to slide over the coming quarters end next year at levels that are not far from zero.

Against this background, the risks of a sustained period of modest deflation are now significant. If we are right, this suggests that after the ECB is done crisis-fighting, it will also have an enormous task to fight too low inflation. As such, large-scale net asset purchases are likely to be part of the eurozone landscape for the foreseeable future.

Headline inflation is likely to experience a rollercoaster ride over the coming quarters given the impact of swings in oil prices. Although we expect oil prices to remain low in the near term, we expect a recovery later this year and next (to around USD 50 p/b by the end of next year). Together with our projection for core inflation, this sees headline inflation turning negative in the near term. A recovery begins in Q3 with headline inflation reaching around 1.5% by the middle of next year. It then falls back down to around 0.5% by the end of 2021. (Aline Schuiling & Nick Kounis)

UK Macro: Major downgrade to our GDP forecast – Q1 GDP came in at -2.0% qoq, better than consensus (-2.6%) but weaker than our own forecast (-1.7%). As expected, private consumption drove the bulk of the decline in GDP, falling -1.7% qoq, but there were also large negative contributions from government consumption (-0.5pp) and net exports (-1.9pp), with exports falling much more than imports. As before, we continue to expect most of the lockdown-related weakness to come in Q2, and following the government’s announcement of its reopening plans – which suggest an extremely gradual pace of reopening – we have significantly downgraded our GDP forecasts. For the remainder of May and June, the UK government plans to move to something closer to the soft lockdown model that has been in place in the Netherlands until recently, with factory and construction work resuming, and non-essential shops reopening. Much of the hospitality sector will remain closed at least until July, and potentially longer. As a result, for 2020 we now expect the economy to contract by -8.5% (previously: -4.9%), with 2021 revised up on base effects, to 5.2% (previously: 2.3%). The net effect of this leaves GDP in Q4 2021 some 3.2pp lower than Q4 2019 levels, which is a bigger shortfall than we had previously forecast (-2.4pp). This shortfall is also much more pessimistic than both consensus and BoE forecasts (which range from 1-2pp below Q4 19 levels), largely because we view the second-round effects of increased unemployment and bankruptcies as likely being larger than in more optimistic forecasts. Given this very weak GDP outlook, we continue to expect the BoE to increase its QE asset purchases target by at least GBP100bn at the next MPC meeting on 18 June, with the risk that it moves to the unlimited asset purchase model that has been adopted by the Fed. (Bill Diviney)