PGIM Fixed Income downgrades Europe/UK growth on energy spike

By Katharine Neiss, chief European economist at PGIM Fixed Income

The risk of weaker growth and higher inflation in the euro area has grown in the past few months. While many countries have made better-than-expected progress in refilling gas storage, pockets of vulnerability remain in certain parts of central and eastern Europe, where a lack of infrastructure means energy supply will be particularly constrained.

With wholesale prices doubling in Europe, the US has promised to fill some of the LNG supply left by Russia, but any meaningful increase in US capacity will take a few years to come online – leaving Europeans vulnerable to the substantial demand-supply imbalance that still remains even after the storage targets are met.

We see inflation peaking at around 10% in Q4, roughly in line with consensus forecast, but see further upside risk from the energy shortage. A 10% further increase in energy prices will likely push up headline inflation by around 0.5ppt, potentially delaying and lifting the peak of inflation to early 2023.

In terms of economic growth, our base case now assumes Europe will experience a mild recession this winter, bringing down 2023 GDP to 0.7% from 1.3%. Our updated forecast also includes a severe scenario, in which growth will contract as much as 2% next year.

Facing all these acute challenges, the ECB will likely have to raise rates throughout this and next year. Under an orderly rationing scenario, on which we place around 50% likelihood, we expect the target rate to be raised to 0.75% by year-end and reach around 1.5% next year – our estimate of the euro area’s neutral rate. There is a 30% chance the energy shortage will beget further rationing, and the ECB will have no choice but to hike rates even more aggressively to around 2% to guide demand lower to meet the constrained supply.

Meanwhile, in the UK, we have revised down our 2022 GDP forecast to 3.5% from 4.1%, while the 2023 estimate was revised down to -0.1% from 0.8%. The economy’s momentum fell sharply in Q2, and the costly passthrough of energy prices to consumers is expected to weigh heavily on consumption.

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