Janet Wilkinson
Hello and welcome to Strategic Alternatives, where we uncover new ways to raise capital, drive growth and create value in an ever changing world with insights and outlooks from the RBC Capital Markets team. I'm your host, Janet Wilkinson, Managing Director and Head of Global Markets Flow Sales, EMEA. And today I'm in conversation with Peter Schaffrick, Chief European Macro Strategist, and Cathal Kennedy, Senior UK Economist. In this episode, we'll take a comprehensive look at Europe's economic outlook for 2025 exploring the key macroeconomic forces and structural drivers of inflation that policy makers are grappling with. Together, we'll unpack the complex interplay between controlling inflation, sustaining growth, and navigating the challenges of a low productivity environment. We'll explore how the landscape has shifted this year, focusing on the political and policy transitions in the US, EU, UK and France, along with the ripple effects of heightened global geopolitical volatility. Together, these forces are reshaping the economic agenda with profound implications for markets, businesses, and investors navigating their path forward. Additionally, with the fixed income landscape shifting dramatically over the past year, we've entered a pivotal moment for investors. Today, we'll explore not just the challenges but also the opportunities that lie ahead. At RBC, we're committed to providing clear and actionable insights to help our clients as Europe adapts to this new dynamic chapter. And so with that set up, Peter, Cathal, welcome to the podcast.
Peter Schaffrick
Thank you, Janet, it's great to be here.
Janet Wilkinson
Okay, great. Let's get started and get into some of the details of what you expect. First, let's go big picture, Peter, what is your expectation for growth, in Europe, in 2025?
Peter Schaffrick
I think it's an excellent starting point. When we cast our mind back at this time around last year, the expectations were very grim, similar to what they are today. Yet the outturn was better than what was expected. So we did have some growth, the labor market has actually firmed further. And despite the interest rate increases that were put through in ‘22 and ‘23 we haven't really seen the negative impacts that most people were expecting, and when I return to the labor market, and the firmness of the labor market is really one of the key central pillars that we at RBC have identified over the last couple of years that is not only different to previous economic cycles or hiking cycles that we had, but clearly also there's a structural element here to it that might well drive us going into ’25. And of course, what also has happened is inflation has come down, that enabled the central banks to put a cutting cycle into motion, and those cuts, they should be supporting the economy going forward. So in essence, big picture wise, we're repeating the call from last year. So without any major deterioration in the labor market, which we do not foresee, it is very unlikely, in our mind, that we get a recession. We can talk about what the GDP outlook is going to be in detail, but the one thing is very clear to us, it seems unlikely that we're plunging into a recession that would be very devastating for the people around Europe.
Janet Wilkinson
Thanks, Peter. So low inflation, lower rates, positive growth. That sounds like a positive message.
Peter Schaffrick
Just to temper expectations a little, when we're talking about positive growth, both in the euro area as well as in the UK, we're thinking about something in the range of one to one and a half percent, which, yes, it's positive, but it's surely not stellar. And there’s a lot of headwinds that, you know, we and the market have identified that are holding us back for ’25. One of the things that was missing this year, is we didn't really have any positive contribution from consumption. We had real wage growth. So inflation was lower than the actual wage increases that most people have seen. So the real disposable income went up, but consumption has not. And one of the things that has happened is that the savings rate went up, and that's probably where all the increase in spending power went, and that's obviously not helpful. And if you look at that picture, the question is whether that changes going forward. We have seen some tentative changes, and that really should help if it is sustained. But then again, there's plenty of headwinds.
Janet Wilkinson
Okay, so positive, but weak growth then, but that shouldn't be inflationary, right? Both the ECB and Bank of England should still have ample space to cut, yes?
Cathal Kennedy
Well, Janet, at had the risk of giving another two handed answer, yes and no, to some degree. First, you know, as Peter mentioned, the central banks are cutting, and we think they will continue to do so. The ECB a little more quickly, the Bank of England thanks in no small part of the impact of the budget here in the UK, a little more cautiously, but both easing nonetheless. As Peter mentioned, falling inflation this year has allowed them to remove some of the restrictiveness that they had put in place. Headline inflation in both jurisdictions is 2.3%, a little above target, but kind of well off the peaks we saw in 2023. But the question is, how far they can ultimately go? And while inflation has come down, energy has been a big part of that. So essentially, kind of an external factor if you will. But the domestically generated parts of the inflation basket, most noticeably services inflation, have yet to convincingly move downwards in either the UK or the euro area, And here we come back to those headwinds impacting growth. We think that the central dilemma facing the UK and the Euro area is this productivity growth backdrop, which has gone from being weak to being either nonexistent or negative, post pandemic. This is bad news for Europe. Productivity gains are basically the central pillar, if you will, of trend growth and rising living standards. But it also makes the central banks jobs that much more difficult. Peter mentioned consumption being weak. We think monetary policy has had an impact on that. So as monetary policies eased, you would expect consumption to come back a little bit. But remember, that's landing in this backdrop of low trend growth, and even so, even at low levels of growth, that growth itself becomes more inflationary.
Janet Wilkinson
So the ECB and Bank of England can keep cutting just not that much. How low can they go?
Peter Schaffrick 1
Because the expectations are very negative, the assumptions for how low the ECB can go are also quite low. Up until about two weeks ago, we were pricing close to 150 and keep in mind, we're coming from 4% and are currently at three. That has increased, to about 175 and change. But the question still in our minds is whether they can go that low. So what the ECB has communicated is that they want to return interest rates to a neutral level. But that's a very elusive concept, nobody really knows where it is. In the last ECB meeting, President Lagarde has flagged that this is a discussion that will be coming up at one of the next meetings in ’25, so where the council will debate where neutral is, and she flagged that it could be anywhere between 1.75 and 2.50. Now some of the council even put it as high as 3% which is where we are at the moment. So, it's entirely unclear to us where they will land. If you put it together with what we said earlier. So there's a productivity problem, and there's probably some lingering inflation, domestically generated inflation in the system. We reckon that the ECB will probably feel more confident leaving the rate somewhere in the middle of the neutral territory. So we, in contrast to the market, have penciled into our forecast two and a quarter, which is currently two cuts above where the market sees it. So, you know, as a consequence, we are quite a bit of an outlier compared to other forecasters in the market, or indeed, where the forwards are sitting.
Cathal Kennedy
And Janet, for the Bank of England, the budget has changed the picture quite a bit from where we were. If you cast your mind back to just the beginning of October, we had the governor Andrew Bailey saying about how the MPC might become more aggressive or activist in the setting of rate policy. Post budget, that's changed quite significantly. We now have the MPC advocating a much more gradual, more cautious approach to the current cutting cycle. And that's essentially because the budget loosens fiscal policy in the near term compared to the plans of the former government. And the strong preference of the bank appears to be to ease policy and then allow evidence to accumulate of how that easing of monetary policy is interacting with the impact of the budget before taking any further policy decisions. So at the present the banks language of communication appears consistent with a quarterly pace of cuts through 2025. That would mean 100 basis points of cuts to take bank rate to 3.75% by end of the year. And with the MPC using those quarterly forecast rounds to assess how the economy is evolving as the combination of easing, monetary policy easing and the budget feeds through. And that's not necessarily how the Bank of England has approached either tightening or easing cycles in the past, but it is in the here and now, the approach that seems most consistent with the bank's current communication.
Janet Wilkinson
Oh, Cathal, that's bad news for my mortgage. And you and I have spoken about my mortgage a lot this year. I don't want to hear bad news about my mortgage, having just bought a new house.
Cathal Kennedy
Well, Janet, unfortunately, that's the position we're all in, as somebody just about to renew their own mortgage in coming weeks. The surprise in the budget was that the government chose to front load so called day to day spending. That's spending on the day to day running of the government's administration, salaries, goods, services, etc. and in the very near term, what happens is that spending ramps up much more quickly than the taxes to pay for it. So that's where the near term fiscal stimulus comes from, or essentially borrowing to run the country. But when the taxes do kick in, and they kick in from April onwards, and they fall mainly on employers in the form of higher National Insurance contributions, so a payroll tax. And what theory would tell you is, is that firms will try and pass that cost on and there's a couple of people who can pay for it. Essentially, one is consumers in the form of higher prices. Two is workers in the form of either lower pay going forward or lower employment. And the third is firms themselves, who might internalize it via lower profit margins. But again, this is something we can only really observe after the fact, and here and now there’s some evidence to suggest that firms, particularly in the service sector, might be looking at employment as the as the way to pass on that cost of increased employer National Insurance workers. But in the near term, what the bank is interested in is that interaction of the near term fiscal stimulus with those changing behavior of employers. How do employers react, which is itself important in the overall picture of the economy going forward. That lends itself to this kind of quarterly, gradual, cautious pace of cuts through 2025.
Peter Schaffrick
Cathal just mentioned fiscal policy, this is a hot topic. And sadly, it's a hot topic in both directions. On the one hand, you have the episodes in France that really sort of highlight how wide budget deficits and high debt levels can potentially move markets. We've seen a significant spread widening of OATs, and it's basically one of the key questions that every investor is asking us. And on the other hand, you have the German budget that is very tight, and the government even fell over the big question about whether to widen the budget and support the economy. So the economy is not really doing that well, as we all know, and the government so far was hamstrung by the so called debt break. So the question is, how is fiscal policy going to come to the rescue of the euro area economy or not, and we do think that the market is probably under appreciating the fiscal loosening that potentially is around the corner. So maybe, as the resident German here, I can say that, but I'm pretty confident that after the elections, what we'll get is a different fiscal position out of the largest economy in the euro area. We'll probably see support programs for the economy. We'll probably see other measures being taken and a big shift in focus on the economy and trying to stimulate the economy. And that seems very clear to me. Now, on top of that, though, they'll probably also change the debt break. At the moment, and the way it's designed, is that the country as a whole can only have a very tiny budget deficit, point three five for GDP, and the German lender can't have one at all. And I guess there's going to be a change coming after the elections, if they have the votes, which I reckon they will. And then maybe the last element, there is an increased focus now on, again, using the European budget, the EU's budget, or some kind of an SPV, as was recently muted in the press that allows the European companies to specifically target military and security spending, which is probably also something that the US will push the Europeans into. But at the end of the day, it's fiscal spending. So the bottom line is, in the UK, we already had a fiscal loosening, as Cathal was just elaborating, but I think for ‘25 that's going to be a key theme for the euro area as well, in part voluntarily, but in part forced by the new US administration.
Janet Wilkinson
Thank you both for highlighting those points. Maybe we can just move on to tariffs. Everyone's talking about tariffs. We've not mentioned tariffs so far. Talk to me about tariffs.
Peter Schaffrick
It's actually quite interesting, because most of our client conversations have different dynamics. Tariffs by and large, are negative for Europe, no doubt about that. And the main reason for that is we're all medium sized but very open economies. We thrive on open trade, and if you put in barriers to trade, particularly if they come out of the US, because the US is obviously a very, very important trading partner for all European countries,. that's not good for us. The question, rather, is whether they are also inflationary or potentially disinflationary, because you can create a scenario where you say, well, particularly if the US introduces tariffs on China, that might be that more Chinese products come into Europe, maybe at a discounted price, and that's disinflationary, and that, at the end of the day, would require and allow the central banks to cut even deeper. But there's obviously also an alternative scenario where, let's say the US strong arms the Europeans in maybe introducing more trade restrictions vis a vis China themselves. And as a consequence, you know, we think it's possible that it could also be inflationary. And when you listen to some of the central bankers, they typically say, ‘Well, initially we reckon that tariffs are going to drive up inflation, and then the second round effect might be a bit different, but we'll have to see that.’ But the long and short of it is, we assume that we will get some kind of tariffs. It's not entirely clear what magnitude and what sequence they will take and on balance, they're probably going to be negative for growth and probably, at least initially, inflationary.
Janet Wilkinson
This is all super interesting and a lot to take in. We here at RBC are all about putting our clients first. So with that in mind, tell me what this means for investors. What are your key takeaways for markets from what we've discussed?
Peter Schaffrick
The market and most of our clients are expecting a relatively negative 2025 and therefore, as I was alluding to earlier, quite a lot of rate cuts. And we just think that's not as likely so we're a little bit more cautious now. In contrast in the US, most people are optimistic, but the market is still pricing quite a few rate cuts, and we are equally concerned that the market might overplay how much the Fed can lower rates. In fact, our colleagues in the US see the terminal rate in the US closer to four, whereas the market sees it quite a bit below that. And they have argued that there is even a possibility, with the US plowing ahead quite strongly, that by next year, we get a theme in the market again, whether the next step from the Fed after they reach their trough in this cutting cycle might be up. So in that case, it's a very difficult environment for fixed income assets in particular. So for the Bank of England, if we were right, and inflation remains a bit more sticky in all European economies post budget, we reckon that the bank can only really remain in the slow lane and the cutting cycle not too dissimilar from what the market is pricing near 3.75. If you then extend that into the longer end of the yield curve, we find it difficult to see how duration can perform this year and we recommend short duration assets in pretty much all markets that we look at. Last but not least, if you look particularly at very long dated assets, ultra longs, the issue of debt sustainability and increased funding, widened fiscal policy that we spoke about earlier might be an additional burden for them. So in a nutshell, we go with a very similar stance into 2025 as we did in ‘24 where we recommend on balance, short duration, maybe slightly long credit less so than this year, because credit spreads are quite tight, but on balance, still long, risky assets rather than duration assets. But Janet, let me turn the tables a bit. I mean, we speak a lot to PMs and analysts about the economy, but you obviously also speak to a lot of people who manage the business of our clients. So what do you hear from these key decision makers about the backdrop going forward? Does what I just explained, and Cathal and I just explained, resonate with what you're hearing?
Janet Wilkinson
Absolutely, you have covered a lot already around what is being discussed at senior business levels. And maybe just to summarize, what's top of mind, the geopolitical risks being more heightened than ever, and the uncertainty that brings. And we all know how much investors hate uncertainty., The Trump agenda and the uncertainty that comes along with that. There's a real concern, re the lack of European growth, especially in France and Germany, and US tariffs being a further headwind. Maybe just touching on that growth piece, we all know that the institutional asset management market in the UK and Europe and globally is under immense cost pressure, and there's a strong move to passive funds, so the uncertainty around growth in the markets puts even greater pressure on this particular part of the market. Trade wars with China are an increasing concern. And then to package all of this together, the impact of all of what I've mentioned on ESG, and where that leaves the ESG agenda. And then finally, regulatory changes, especially in the US, and the impact on how people will invest and can invest. There could be positives or negatives that come out of this, but to end on a bit of a high, there's a real strong outlook for M&A and associated deal activity, and there's this real strong outlook for corporate credit, where yields are still high. So I suppose that's a strong point to end on. Thank you so much. Thank you for joining the podcast today.
Peter Schaffrik
Thank you for having us.
Cathal Kennedy
Thank you, Janet, thanks for having us.
Janet Wilkinson
To our listeners. That's all for this episode, thank you for tuning in today. Please remember to subscribe to get more great content and be alerted about future episodes. You have been listening to strategic alternatives the RBC podcast. This episode was recorded on December the 16th, 2024. Listen and subscribe to Strategic Alternatives on Apple podcasts, Spotify, or wherever you listen to your podcast. If you enjoyed the podcast, please leave us a review and share the podcast with others.