In recent weeks, we’ve been highlighting the improving macro environment in the UK and Europe. Much of this reflects falling prices for natural gas. There is a real prospect that inflation falls below 3% at the end of this year in both Europe and the UK. As the fear of sky-high energy prices recedes, confidence should pick up leading to stronger spending.
So far, the evidence has been supporting this scenario. Economic numbers have come in much stronger than expected in the both the UK and the euro area. Despite concerns about the credit crisis in the US and UBS’s takeover of Credit Suisse there have been no runs on banks in the UK or Europe and worries about Deutsche Bank have receded.
Inflation has already fallen significantly in the euro area – the latest figures came in at 6.9%, down from a peak of 10.7% in October last year. Progress has been much slower in the UK where inflation remains above 10% but it is only a matter of time before it plunges here too.
The factor we expect to add further impetus with time is consumer spending in Germany. Consumer confidence had picked up, real incomes are now growing, energy bills are falling and there is plenty of unspent cash around after the generous fiscal support during covid.
We are not talking about a boom of course. But the widespread fear of recession that was evident last autumn has proven groundless and we should see slow steady growth in Europe and the UK in 2023. One major headwind for the UK is the rise in mortgage rates. Yes, mortgage rates have risen in Europe too, but the impact is strongest in the UK, partly because mortgage rates fell so low but also because turnover in the UK housing market is higher than in many other European countries.
This has important implications for monetary policy. The European Central Bank is pleased that headline inflation has eased but core inflation has not fallen, and wage inflation is accelerating. With growth prospects improving, we expect the ECB to continue raising rates. If, as we expect, the US heads into recession later this year we could see US rates fall below those in Europe by year end, which would be a truly dramatic change. The US employment figures, out at the end of this week will be crucial in this regard.
This all suggests the euro and sterling could continue to strengthen against the US dollar. The rise of the pound however, will be limited by the drag on the economy from mortgage rates which means that the Bank of England may not raise rates much further. With a better economy, European equities could also outperform their US counterparts.