Speaker 1 (00:06):
Hello and welcome to Strategic Alternatives, the RBC podcast series where we uncover new ways to raise capital, drive growth, and create value in an ever-changing market environment. I'm Vitos Grado, global Head of Mergers and Acquisitions here at RBC Capital Markets. Today is a very special episode of strategic alternatives where we'll be examining the forward macroeconomic outlook for Europe with Peter Schaff, Rick, our Chief European macro strategist and Catal Kennedy senior UK economist. A reminder to our audience this episode is one in a four-part series where RBCs macro experts will be discussing the key economic indicators and swing factors affecting markets, industries, and investors in the year ahead. Peter Khal, welcome to the podcast. Can you talk us through the outlook for Europe and the uk?
Speaker 2 (01:00):
Well, thank you Vito for having us. It's a great pleasure being here. I think what I'll probably do is I'll set the stage and then I'll hand over to Al to go a bit into the nuts and bolts of things. At the time of recordings, actually quite interesting because what we're seeing is that the market is very clearly pricing that we've reached peak interest rates of pretty much all the central banks, DECB and the Bank of England including, and really on the back of relatively weak inflation data in particular, but also some communication that actually came out of the us. The market has now priced a relatively aggressive rate cutting path for the central banks with, for instance, here in Europe, the ECB seemed to be cutting rates round about a hundred basis points over the course of 2024. And I think one of the questions really is whether the weakness in the economy that we're seeing at the moment carries through to 2024 or to use the catchphrase that we used as a title for our 2024 outlook that we just published. How weak is weak enough. And I think if we look at that from an economics angle, I think that's the perfect segue to bring Kaha in because he actually knows way more about the strength of the weaknesses of the economy than I possibly can.
Speaker 3 (02:10):
Thanks Peter. Thank you very much for that very kind introduction. I suppose if I was to sum up our outlook for the economy, if you will, it will be
Speaker 2 (02:17):
Subdued
Speaker 3 (02:19):
To use a word. Now you mentioned we have seen growth weakened in the second half of 2023 in both the UK and the Euro area, and the reasons for that are fairly well stated. We've had households under pressure as inflation has outstripped wage growth, but equally we've also seen the impact of central bank action really begin to feed through particularly those interest rates, sensitive parts of the economy if you will. I mean in our 2024 outlook note we highlight here in the UK and the impact on construction and housing activity in particular. Now the outlook is essentially for more the same that subdued growth that we've seen in the second half of this year carrying through to certainly the first half of next year. Indeed we're only penciling in growth to 0.2% in both the Euro area and the UK for 2024. So I think subdued anemic pick your description as you will now, the reason for that is we are continuing to see the central bank action, the cumulative effect of what's been announced to date in terms of policy tightening continue to weigh on the economy in the uk.
(03:22):
We just highlight that in the next three quarters, you're still seeing quite a lot of the Bank of England's policy being transmitted, particularly through the mortgage market as two year deals that were agreed the prior to Q3 2022 come up for renewal last quarter of this year and the early quarters of next year. So the policy transmission still very much feeding through putting pressure on households in the UK in the Euro area. The impact so far has shown up more in investment. We've seen corporate loan demand, for example, soften in recent surveys with firms citing higher interest rates and basically reduce need for investment going forward as reasons for that. Now it's not all glim. There is a glimmer of hope that glimmer of hope we think comes true in the second half of the year. We expect inflation to drop more sharply than wages.
(04:12):
That means that real incomes should rebound in the second half of next year. Particularly also as we see the real brunt of central bank action having passed through the economy. So while subcu growth in the first half of next year do see some hope for optimism, some glimmers of hope of be real for the second half of the year. But I think kind of if I could reflect a bit on where we are in terms of central banks and their reaction functions, I think it's less really about the growth outlook of itself and how really it's impacting on the key metrics we think anyway, they're still looking at which is the labor market and inflation.
Speaker 2 (04:45):
I think this is an excellent point, is a bit of a pet subject of mine. I've been for better part of the year or even before that I've been saying that we're in a jobs rich slowdown, a jobs rich recession. And actually you said the glimmer of hope really is that we're essentially reestablishing some of the lost disposable income as real wage growth turns positive because of wage growth is still relatively elevated and clearly what we've seen is that the labor market or the labor markets I should say across Europe have really reacted very strongly lately. But given that you are particularly an expert on the UK and given that we've seen sort of a little bit of a softening in the UK labor market specifically, do you reckon that's the canary in the coal mine or is there further strength to come even if the economy doesn't necessarily inhibit stellar growth?
Speaker 3 (05:36):
You've hit the crux of the issue there, if you will, in that last statement. The conundrum we've been trying to answer for the last best part of a year, 18 months now is why with this very weak output growth has employment growth and remained strong, why has unemployment remained low? Why has the labor market remained tight? And that's going to be the conundrum still going forward, if you will. Now you mentioned the UK and we have seen the labor market loosen here a bit, but you must remember it's from a very, very tight starting point. As best as we can make out, given the problems of the data in the uk, we think unemployment's around 4.2% could be lower than that in the Euro area, 6.5%. Again, historically very low. So we are listening, but we're listening from a very, very tight starting point here in the uk.
(06:24):
So far the cooling we've seen has been of the, what I would describe as the benign variety. We've had vacancies come down, we've had inactivity come down boosting labor supply. So it's been less true job losses if you will, and more true at a supply response in the uk, in the Euro area, there's some indications that we may be seeing some labor hoarding. Employment in terms of numbers is high, but hours work are still below pre pandemic levels. The last set of data we have did show some employment losses in the uk, but not to a great extent. So like I said, going forward, if you are to engineer more cooling in the labor market, it's going to have to be of a more painful variety. It's going to have to be through increased unemployment via reduced unemployment, not the more benign variety we seen today.
Speaker 2 (07:12):
For all the listeners out there, I mean one of the key things that we are highlighting over here in Europe generally is just as Kaha has been explaining that it will just take a lot of time until we've really eaten through the strength in the labor market. And of course the other question that we need to answer here is if the labor market weakens only slowly, how does that translate? How does that feed through into inflation? And just again, to put my market's head on, the market clearly is expecting that inflation is returning back to target and stays there by the middle of next year. And you can already see that this is one of the things why we are currently in the market relatively confident that the central banks can start cutting. And again, I mean I personally and I bring it back to Kaha in a second, I personally think that the risk clearly is and that the central banks will not be able to or will not be confident to actually deliver what's currently priced in. But back to you Kaha, I mean just fill us in a bit about the dynamics as far as inflation is concerned.
Speaker 3 (08:11):
Well, Peter, the simple answer to that question is we expect the inflation to continue to fall through 2024. Now if you look at what's happened this year in 2023 in respect of inflation, most of the drop we've seen has come from two sources, energy and food, non-core items if you will. And that to a large extent has just been base effects, very high increases in energy and food prices through 2022. And so year in year, our inflation rates look a bit better in that respect. Now that said, we are seeing core inflation beginning to fall. The latest Euro area numbers indeed surprise to core inflation, surprise the downside. We think that's mainly due to manufacturing goods so far. One thing we've been highlighting in the UK is that quite a bit of the drop in core inflation has come from household goods and that's the kind of goods that are associated with people moving home, people buying furniture, people buying furnishings, the kind of things you would associate with housing transactions, which we just said has been impacted by central bank action.
(09:15):
And it's true also to say that the easing of price pressures is much more firmly established in manufacturing than it is in services. So when services inflation is still high, and we think probably more challenging to bring down over the course of the next year or so, and this is to go back to the liver market because of wages, you have wages in the UK private sector wages still running at close to 8% about double we think of what the Bank of England consider consistent with their inflation target. Until you see some easing of wages, it'll be hard to bring about that easing of services inflation, certainly on a sustainable basis if you will. So we get to the end of next year and we still see inflation above target in both the UK and Euro area, I should say a little bit more. So in the UK around 2.7%, but around still around 2.4% in the Euro area.
Speaker 2 (10:10):
Well see Vito. And I think that really encapsulates the essence of the crux, so to speak, that we will have in 2024. So if I wrap my arms around it, we see an economy that's relatively weak,
(10:23):
But it's not falling apart, but it's certainly not a stellar growth path. We also see a labor market that's still relatively strong. It's coming down, it's weakening, but from an exceptionally strong base and we have inflation that's coming down, but also from relatively high levels, it's probably not going to reach the target soon enough. And that meets a market that at the moment is implying already a relatively sharp string of rate cuts whilst at the same time the speakers from the central banks tell us we're going to sit here and wait. So the question is how does one position, and that's really the last point I'd like to make. We think that it's still too early to really position extremely on the long side in the bond market. So a lot of people are buying bonds, but if they do so we would recommend them to stay shorter maturities as a better risk reward, trade off, and probably add some credit spreads over duration risk.
(11:15):
We also think there is something to be done here in selling a few more on the market side and selling government bonds with other assets such as swaps or as I said, against credit or maybe even selling some volatility. Because again, what we think is the market is probably expecting too much movement from the central banks, but you can also see or already see in what I said is this is an environment where risky assets are probably going to do reasonably well because the economy is not falling into an abyss and we are already seeing equity markets doing well and we're seeing credit markets doing well too. So that's roughly the picture that we see unfolding and I hope that gives everyone who's listening a little bit to hang their hat on.
Speaker 1 (11:54):
Peter Kafa. Thank you both. It's been an insightful conversation in the recent developments affecting the economic outlook for the UK and Europe. Stay tuned for more insights in future episodes of strategic alternatives. And thank you for joining us today. You have been listening to Strategic Alternatives, the RBC podcast. This episode was recorded on November 30th, 2023. 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. Thank you.
Speaker 4 (12:37):
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