Running Out of Gas

Eurozone

• A strong labor market and accumulated household savings have supported growth in the eurozone. The effects of the Ukraine war are taking an increasing toll on European economies, though. The continent’s expansion will run out of gas as rising energy prices, rationing and weakening external demand are likely to weigh on activity. We continue to expect the eurozone to slip into a technical recession starting in the fourth quarter of 2022.
• Inflation has not peaked and is unlikely to do so within the next month or two as energy and food costs continue to climb for European consumers. High inflation and the European Central Bank’s data-dependent approach mean that the central bank will front-load hikes before the economy slips into recession at the turn of the year. We expect a 50 basis point hike in September, followed by 25 basis point movements at each of the two subsequent meetings.

United Kingdom

• The U.K. economy contracted in the second quarter. The decline was largely a result of statistical noise from fewer working days in June along with a decline in health activities following the wind down of vaccinations and testing. With a full quota of working days in July, we expect the economy to rebound, avoiding a technical recession. However, the consumer sector will be challenged by surging inflationary pressures and tighter financial conditions. This will push growth back into negative territory in the fourth quarter.
• Labor market strength remains a saving grace for the British economy. Yet there are no clear signs of the U.K. facing an inflationary wage-price spiral as pay continues to fall in real terms. Nevertheless, the risk of inflation becoming more embedded will force the Bank of England to tighten further. Another half-point increase looks likely in September, followed by 25 basis point hikes in November and December.

Japan

• The Japanese economy reached an important milestone of recovering to its pre-pandemic size in the second quarter. Real GDP grew at an annualized rate of 2.2% compared to an upwardly revised 0.1% for the first quarter. Consumption, which accounts for over half of the country’s output, was a key driver as COVID restrictions eased. Growth could have been stronger, had it not been for a negative drag from inventories. We expect recovery to continue, supported by pent-up demand. But higher inflation and softening external demand will be headwinds.
• The lagged recovery has turned the Bank of Japan (BoJ) into an outlier, maintaining a highly accommodative policy. In the absence of sustained wage and price gains, we expect the BoJ to stick to its monetary policy framework and the political leadership to stick to Abenomics.

China

• The Chinese economic recovery appears to be faltering. Activity weakened in July, with growth in industrial value added, fixed asset investment, and retail sales undershooting expectations. As a response, the People’s Bank of China cut its policy rates by 10 basis points. The central bank move suggests that the economic malaise goes well beyond the COVID-related disruptions, as the need for stability outweighed their concerns around the risks of rising debt, inflation and currency pressure.
• We expect infrastructure and credit easing to play a bigger role in the coming months, but as reflected in the incoming data, their impact could fade owing to the zero-COVID policy and property downturn.

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