How the economies of the EU and the US will go

 by Steven Bell

Facts and scenarios on the economies of the EU and the USA. Commentary by Steven Bell of Columbia Threadneedle Investment

Last week the Bank of England raised its interest rate by 0.5%. This came after an even more substantial move by the US and a similar rise by the European Central Bank.  Let's analyze the reasons behind the increases and what it will take to end them.

Although inflation is at similar levels in Europe and the United States in nominal terms, the composition is very different. In the UK and the euro area, energy prices are primarily responsible, with gas prices leading the way. Domestic pressures predominate in the United States. Wages are rising sharply, much faster than in Europe, as are rents.

Has the Federal Reserve acted too slowly?

Last week's surge in employment highlights how strong the US labor market is and I don't see a scenario where these pressures can be contained without a recession. This means that the US Federal Reserve will likely have to continue raising rates until recession is imminent. And given the underlying strength of the U.S. economy, I expect U.S. interest rates to rise a lot because, in my view, they started monetary tightening too late.

Further rate hikes in the UK and euro area could be modest

In Europe the story is different. Forward natural gas prices for this winter are 12 times higher than they were before Russia's invasion of Ukraine. This is a huge increase. In the United Kingdom, the increase is smaller, but the tenfold increase is still unprecedented. The result, in my view, is a recession. But it will be a recession of a different kind than that of the United States. This is a supply shock that does not require a monetary policy response. Gas prices will not rise again 10-fold and markets expect a decline in the medium term.  So, much of the rise in inflation will be transitory and since the blow to real incomes will still generate a recession, there is no need for central banks to do more in this regard.

But that's not all: interest rates have reached almost zero in the UK and negative in Europe; therefore, they are rising to more "normal" levels and, considering other factors, I suspect that the Bank of England and the European Central Bank can raise rates only slightly.

Implications for markets

Recessions are harbingers of bad news for corporate earnings, whether or not they reflect a supply shock. And rising interest rates combined with a recession is a double blow.  After a really terrible first half, both equities and bonds performed well in July. And stocks started August in an overall positive way. But I think we are going to have some difficult months ahead.

As for the US, once inflationary pressures have eased, the Fed may consider cutting rates or, at any rate, suspending policy. At that point, corporate earnings and equities can begin to recover. There is no doubt that European equities would benefit to some extent. But even if gas prices here fall a bit, it is unlikely that they will return to previous levels anytime soon.

Inflation must be brought under control and this will be painful

The rally in risk assets occurred for the seemingly perverse reason of weakening economic data. This has led markets to conclude that the US Federal Reserve will raise interest rates only slightly and cut them in 2023. Stocks have fallen so far in 2022, despite strong earnings growth; so, surely stocks are a "buy" if interest rates stop rising?

The big flaw in this argument is that it suggests that interest rates are close to a level that will reduce inflation and that this will happen without a recession. The reality is that US inflation has been allowed to become too high and too persistent to be appeased by a simple slowdown in the economy. It is true that US GDP contracted in the first two quarters of 2022, but this is not a sensible reflection of the economy. After all, the U.S. economy added as many as 2.7 million jobs over that period. Wage inflation has accelerated sharply this year, more than the Federal Reserve and markets expected. The same applies to rentals. Sure, gasoline prices have fallen from the highest levels and the prices of other commodities have fallen, but these factors have an insignificant influence on inflation relative to rents and wages.

In my view, the US needs a full-blown recession, with a significant rise in unemployment, to bring inflation back towards the Fed's 2% target. This is likely to require a significant increase in interest rates, which will be accompanied by a decline in corporate earnings.

Investors are already expecting a recession, but stocks could fall

It is true that investor sentiment became exceptionally bearish a month ago and that most expect a recession. It is therefore possible that stocks should not have to fall that much, but my guess is that they are still in a bearish trend.

We cannot expect Europe to provide much support. Unlike the United States, wages and rents are not the main source of inflationary pressure. In Europe, it is the cost of living crisis that dominates and it is difficult for Europe to avoid a recession with soaring energy bills . The numbers are frightening. In the UK, the average household energy bill will exceed £3,000 in October, before rising again to £4,000 in January 2023. Of course, a part of this figure will be offset by government support, but this will only mitigate the impact, will not protect the industry and will constitute an additional constraint on public finances. Conditions vary in other European countries, but for Northern Europe and Germany in particular the outlook is very bad.