Global divergence beginning to show, or first dominoes to fall?

Remember last week when we discussed headline growth numbers in the US printing positive? Not so much in the Eurozone, where the EU recently announced that it will grow slower than expected in 2023 and 2024. As continued high inflation provides a drag on the region. The European Commission (EC) revised down its growth forecasts to 0.8% growth in 2023 and 1.3% growth in 2024, numbers that certainly qualify as “sluggish” or “anemic”. Interestingly, the EU economy seems to be acting far more as expected than the US: with prices remaining high, EU consumers are pulling back, contributing to a slowdown. This is unlike what the data show in the US, where, as discussed in our last letter, higher prices are not appearing to damper US consumer spending. Something is definitely off with the US economy, in many views this elevated consumer spending is being sustained by increasing consumer debt balances and lowered savings rates, but time will tell.

Despite the lowered growth for the EU, the labor market still appears strong, and wages still appear to be growing – EU citizens are just refusing to spend as much for higher priced goods. Inflation is also a bigger issue in the EU currently, with the EC forecasting inflation of 5.6% for the full year 2023, while the latest forecasts for the US are somewhere around 3.5%-3.6%.

Drags on the EU are coming from places like Germany, Italy and the Netherlands, with Germany already in a recessionary environment. A recession is negative growth, as Germany, usually the economic powerhouse of the EU, is projected to contract by 0.4% this year. To paint with a very broad brush, demand is notoriously more price elastic in Germany, compare with the US, meaning German consumers will more quickly change their consumption habits if prices change.  It has been dealing with high energy prices since the beginning of the Ukraine-Russia War, and this summer OPEC nations began a cycle of output restrictions, further driving up energy prices, which in turn provides further inflationary pressure and hence lower consumer spending. The concern for many countries todays, though we’re focused on Germany, is whether these slowdowns will be temporary hiccups or whether they are signs of extended stagnation, similar to the case study of Japan’s “lost decade” in the 90’s. Only time will tell on that front, and in our view that would be the result of more than just conventional economics – in other words, potential political or social unrest.

 In addition to domestic consumption, Germany is also strongly dependent on its export economy, that is, people globally buying German products, particularly from its manufacturing economy. So this would make Germany highly sensitive to slowdowns in other countries. For example, China is Germany’s most important trading partner, and auto manufacturing is a critical piece of the German economy, but China imported 24% fewer cars from Germany in Q1’23.

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While global trade is critical for progress, this is also an example of some risks presented with an overreliance on it – in Germany’s case a reliance on energy from hostile geopolitical regimes, and a reliance on its manufacturing exports as a cornerstone of its economy. In some cases, this is unavoidable, as not every country is lucky enough to have rich deposits of natural resources, but in other areas, economies will have to figure out ways to become more resilient to these types of risks going forward.