By Maximilian Korell
The European economy is changing course fast: Lower inflation comes with the price of lower growth, which could be just beginning.
Earlier in the year, we argued in the “Can German Consumer Savings Raise Domestic Growth?” blog post that, for the German and much of the European economies, the consumer is unlikely to come to the rescue when it comes to growth.
Similarly, we said that elevated wage settlements would not cause a reacceleration in growth and inflation dynamics. Since then, German retail sales have contracted – declining 0.7% year-to-date compared to the initial expected increase of 4.8% – all in nominal terms.
We have observed for a while now that markets appear to be overly optimistic around European growth and inflation dynamics, both of which would require increased consumer spending to materialize – to be precise, a transition to demand-pull inflation from the current cost-push state.
Fast-forward to today and against many expectations, European inflation has dropped to a two-year low while quarterly GDP growth has moved negative.
Without going into too much detail, inventories were built in the second quarter and domestic demand contracted in the third quarter.
In our view, this does not bode well for growth and inflation going forward, nor for the industrial labor market, which is slow to turn but when it does can be sticky as on the way up.
With that in mind, the services side will eventually follow as wages are too high and pricing power diminished.
Since the last ECB meeting, growth and inflation data have materially undershot the central bank’s forecast and look to continue to do so until the central bank’s next meeting in December.
With the right tails on growth and inflation becoming increasingly unlikely, we believe it is only a matter of time before the market starts pricing in more aggressive cuts to the benchmark interest rate, with, as of this writing, only 80 basis points in cuts currently expected for the next year.
Indeed, market pricing so far this year has paid little attention to diverging economic developments between Europe and the U.S.
With the above in mind, investors can take steps to benefit from these diverging fundamentals across fixed income and currencies.
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