Recession threat hangs over Europe’s fragile economic growth

The eurozone's recovery from the pandemic is already showing signs of flagging even before it meets the economic storm clouds heading its way.

The danger of a recession loomed into view this week after Russia halted gas flows to Poland and Bulgaria, offering a foretaste of what the region might have in store. But even without the energy rationing, such a move might provoke, the outlook looks ominous, underscored by weaker-than-expected growth reported Friday.

European factories are signaling distress amid record inflation and a stubborn supply squeeze, aggravated by strict Covid lockdowns in China. Meanwhile, any catch-up on leisure and travel by pandemic-liberated consumers may fade, not least as price increases eat into incomes. The coronavirus itself could return with a vengeance.

European financial markets reflect the gloom, and economists at Morgan Stanley are among those seeing a "meaningful slowdown" in the second half. Corporate giants including Germany's BASF SE are bracing for "serious disruptions," and the OECD is warning that governments underestimate the impact of the war in Ukraine.

What that suggests is that a year that began with the region extending its growth beyond pre-Covid levels, and offered the prospect of further tailwinds from European Union fiscal aid, now risks becoming another sorry episode for the European Central Bank in the single currency's history of frustrating setbacks to growth.

"The economy may show resilience in the coming quarters, but the problem is, what will happen at the end of the year?" said Anatoli Annenkov, an economist at Societe Generale SA in London. "We don't know what will happen with wage growth and fiscal stimulus in 2023, there's as much concern over China as there is over energy costs, and it's easy to become pessimistic in light of the war."

Given the backdrop, Europe's main equity benchmark has struggled to find its footing this year and widening bond spreads are feeding concerns that fragmentation will return to the 19-nation eurozone.

"With inflation reaching 7.5% in April, we expect the cost-of-living crisis to deepen and put a lid on growth in the second quarter."

—Maeva Cousin and Jamie Rush, economists. Click here for the full report

First-quarter gross domestic product data didn't offer cause for hope. The euro area grew only 0.2%, less than economists anticipated, hurt by a contraction in Italy, stagnation in France and weaker-than-expected growth in Spain.

Indicators since then aren't much better. Factory output and new orders are close to grinding to a halt, and business confidence across major economies has declined since the start of the year. That's left services to shoulder the burden, undermined by waning consumer confidence.

"Manufacturing will be very weak in the coming months and quite likely contract in the second quarter," said Veronika Roharova, an economist at Credit Suisse International, who predicts euro-area growth of 2.8% this year. Still, "services are strong and household savings high, the labor market continues to look healthy and fiscal support is ensuring we won't see a spending slump."

Despite such tailwinds, economic forecasts for this year are being slashed. The International Monetary Fund cut 1.1 percentage point off its projection this month and now sees growth of 2.8%. The Institute of International Finance anticipates just 1% expansion.

ECB officials acknowledged this month that growth risks have increased "substantially," but they remain optimistic they can deliver an accelerated exit from crisis-era stimulus to combat inflation at a record 7.5% in data on Friday.

Some policymakers are touting the first interest-rate increase since 2011 as soon as July, and even Russia's complete halt of gas deliveries to Poland and Bulgaria and the prospect that euro-zone countries could also be shut off next doesn't seem to deter them.

While "this would definitely have a more negative, stronger immediate effect" Governing Council member Madis Muller said on Wednesday, he added that "the risk of an economic contraction in the euro area on the whole is more likely to be small."

The effect in Germany, the region's biggest economy, might be more significant. First-quarter growth of 0.2% matched expectations, but the Bundesbank sees a risk of it shrinking nearly 2% this year if the war escalates and an embargo on Russian coal, oil and gas leads to restrictions on industry.

Scores of companies including BMW AG and ThyssenKrupp AG have warned earnings could be affected, and utility Sniper SE said Wednesday that the economic toll of any stoppages in gas supplies would be "dramatic."

German Economy Minister Robert Habeck insisted this week that a full embargo on Russian oil would be "manageable." Meanwhile the EU has been discussing new sanctions targeting the commodity, and Emmanuel Macron's victory in French presidential elections may reinforce the bloc's cohesion in addressing challenges together.

The ECB also highlighted this month that fiscal measures to help households cope with surging inflation are helping. The prospect of such policies being extended, particularly in the event of a Russian energy shut-off, could provide a cushion for the economy, though at a cost to public finances.

"Fiscal measures, including at EU level, will help shield the euro area from the impact of the Russian invasion of Ukraine," ECB President Christine Lagarde told the IMF meetings last week. The central bank's next policy decision is on June 9.

Disclaimer: This article first appeared on Bloomberg, and is published by special syndication arrangement.