What to Make of the Eurozone’s Slowing Growth

Following US Q1 gross domestic product’s (GDP, a government-produced measure of economic activity) surprising contraction last Thursday, statistics agency Eurostat reported slower-but-positive eurozone Q1 GDP growth of 0.2% q/q last Friday—with output mixed across the four largest economies.^[i] We aren’t saying the report is all sunshine and roses by any stretch. Yet rather than cheer the currency bloc’s resilience, we observed financial headlines warn the slowdown could portend recession (an extended, broad economic downturn) driven by the Russia-Ukraine war and high prices. Whilst eurozone Q1 GDP numbers don’t reveal much new information on the economic front—and we aren’t dismissing the possibility of a regional recession—the broad reaction to them reveals how universally dour sentiment is in Europe today, in our view.

Of the 19 eurozone members, 7 reported Q1 GDP last Friday.^[ii] Portugal (2.6% q/q) and Austria (2.5%) registered the fastest growth, but most commentators we follow focused on the eurozone’s four largest economies.^[iii] Whilst Germany (0.2%) and Spain (0.3%) grew, France recorded flat output (0.0%) and Italy contracted (-0.2%).^[iv]

Exhibit 1: Change in Quarterly GDP for Eurozone Nations, Q2 2021 – Q1 2022

Source: Eurostat, as of 29/4/2022. Quarter-over-quarter real GDP growth rate, Q2 2021 – Q1 2022.

The consensus estimate for Q1 eurozone growth was 0.3% q/q after Q4’s 0.3% reading, so some economists we follow suggested the weaker-than-anticipated result signalled growing pressures from the war in Ukraine and soaring energy prices.^[v] A separate Eurostat report released last Friday showed the harmonised index of consumer prices (HICP, a measure of consumer goods and services prices across the economy) rose a record-high 7.5% y/y in April—with energy prices up 38.0%—prompting some analysts we follow to conclude the economic situation may get even worse since energy tensions with Russia are building.^[vi]

Whilst Eurostat’s initial estimate doesn’t provide much detail on the underlying GDP components, individual nations’ statistics agencies highlighted some country-specific trends. According to France’s National Institute of Statistics and Economic Studies (Insee), French GDP stagnated due to weakness in domestic demand: Household consumption fell -1.3% q/q, with hotel and restaurant services (-5.3%) and goods purchases (-1.7%) detracting most.^[vii] Both Insee’s findings and our own research suggest that weakness appears related to early-year COVID restrictions when Omicron topped headlines.^[viii] Now, these quantitative data may appear inconsistent with the message from purchasing managers’ indexes (PMIs, which are widely monitored monthly business surveys), especially since France’s services PMI showed expansion from January – March.^[ix] But PMIs reveal the breadth of growth—i.e., the rough percentage of businesses that enjoyed higher activity—not its magnitude (i.e., how much a business grew or shrank). Though other French services industries expanded, that growth may not have been enough to offset the weakness in COVID-impacted industries. As Insee also noted, both transport services (1.9%) and services to households (0.5%) grew, albeit at much slower rates than Q4.^[x] 

Germany’s national statistics agency, Destatis, provided fewer details than its French counterpart, but the group attributed Q1 GDP growth to higher capital formation (which reflects domestic investment and changes in inventories) and noted the trade balance (value of exports minus value of imports) weighed.^[xi] Future estimates should provide more colour, as some of these GDP components are subject to interpretation. As we noted last week in our commentary on US GDP, inventory changes aren’t automatically good or bad economically. For example, if inventory change adds to GDP, we think that could mean companies are stockpiling in anticipation of consumer demand (good) or businesses could be having trouble moving product (not so good). In the case of Q1 German GDP, we think the former scenario is more likely as demand for limited goods—strained by supply chain issues—still appears strong according to our research. Similarly, if the boost came from business investment, we think that would also be an economic positive. Destatis also noted the Russia-Ukraine war has added more short-term unknowns, which may subject results to larger uncertainties than usual.^[xii]

A separate report on trade issued Wednesday added a hint of clarity, in our view. German exports fell -3.3% m/m in March, with exports to Russia falling -62.3% m/m.^[xiii] We think the size of this drop, which put monthly exports to Russia at just €0.9 billion—0.7% of total German exports—suggests the lion’s share of sanctions’ impact on German exports is over.^[xiv] Imports from Russia, however, fell just -2.4% m/m, which could worsen if an EU energy embargo on Russia is enacted.^[xv]

The limited amount of quantitative data in the GDP report didn’t prevent commentators we follow from publishing a raft of dour takes, with many arguing war-related disruptions will push high energy prices higher, putting Europe in an energy crunch and making recession inevitable. However, we think the dominant scepticism overshadowed some better-than-expected realities. Take Germany. Over the past couple weeks, we observed many analysts warning the eurozone’s largest economy would contract for a second straight quarter in Q1—putting the country in a recession according to one popular definition. Official numbers confirmed that didn’t happen, but many commentators we follow seemed to focus less on that better-than-anticipated result and moved their attention instead on France and Italy’s worse-than-expected GDP readings.

To be clear, we aren’t dismissing the Continent’s economic headwinds. The inflation rate is likely to remain elevated for a while, weighing on both businesses and households—and we sympathise with those suffering related hardships. But in our view, many of today’s dire economic projections are extrapolations of worst-case scenarios—e.g., the EU or Russia suddenly severing energy ties, leaving the Continent short on supply. Yet as we have highlighted recently, reality appears more complicated than that. Moves against Russia thus far have been small, and we think future, larger potential EU moves are also likely to be gradual—if they can overcome some members’ (Hungary, Austria) objections and actually implement an energy embargo. Even with the draft proposal released by the EU Wednesday, we think there are many unsettled details regarding a potential EU ban of Russian oil. Even so, Europe is finding energy elsewhere: see natural gas exports from the US, Qatar and maybe even the UK.^[xvi] Whilst these sources aren’t a complete substitute for Russian energy, we do think the alternatives can cushion the blow to an extent. Moreover, the available economic data suggest eurozone businesses continued expanding as Q2 got underway despite the war raging on.^[xvii] We have yet to see meaningful economic evidence this regional conflict is morphing into a larger one capable of engulfing the eurozone economy, let alone the global one.  

We are watching the situation closely as war and politicians’ responses to it are inherently unpredictable. But based on our coverage of financial headlines globally, the prospect of a eurozone recession is widely discussed at this point. Since markets are efficient discounters of information, in our view, they have likely already begun reflecting some economic weakness in stock prices at this point. Recent eurozone market returns relative to global stocks underscore that.^[xviii] In our view, that also queues up some positive upside surprise should reality turn out slightly better than the doom and gloom widely expected today.