Is now the time for cautious economic optimism?

30 January 2023

Economic outlooks have moved from depression to ‘cautious optimism’. Dr Christof Engelskirchen, chief economist at Autovista Group, explores this positivity and what could possibly derail it.

The 2023 World Economic Forum recently concluded in Davos. There was a palpable sense of relief that the event took place in January 2023, rather than in October 2022.

Within just three months, many institutions swapped gloomy outlooks of a global recession for predictions of subdued growth over the coming quarters. The Eurozone’s economy grew by around 3% in 2022, which was remarkable given the circumstances. In December, the European Central Bank (ECB) projected 0.5% GDP growth this year.

There are a couple of reasons for this change to the outlook. First, Putin’s strategy of using energy as a weapon has not played out. Russia decided to cut gas supplies and exported roughly a quarter less gas in 2022 than in 2021. In the grand scheme of things, this decision has not hurt Europe any more than it has harmed Russia. Europe stands largely united and is carefully orchestrating its responses to the war.

Less anxious markets

Second, energy prices have fallen substantially. There are fewer concerns about a sustainable source of energy over the coming years, as new LPG terminals have rather swiftly and successfully been put into operation. Many more LPG projects have been announced worldwide to transform natural gas into liquid gas and thus enable transportation.

Third, markets are less anxious about an energy shortage. Power prices dropped significantly during November and December last year. Spot markets are now pricing gas at pre-war levels although this is still roughly triple the amount recorded before 2021. It is unlikely prices will return to this level either. Cheap gas will not be available from Russia for the foreseeable future, making investments into LNG production and shipping more lucrative.

Fourth, a warm winter has so far helped keep gas demand down. Consumers and industries have also cut consumption amid rising prices. In Germany, the federal agency responsible for gas (Bundesnetzagentur) reported that the beginning of 2023 saw the temperature-adjusted consumption of gas shrink 24% compared to reference values from 2018 to 2021. This illustrates the elasticity of demand.

Fifth, labour markets are thriving across Europe and the US. High levels of employment help economies by supporting private consumption. Of course, tight labour markets also drive wages up and thus fuel inflation. Throughout 2022, unions’ demands were moderate in the sense that they did not propel further inflation. But this could change quickly in 2023, depending on how inflation develops.

Inflation still ‘way too high’

Sixth, although inflation is, as ECB president Christine Lagarde put it, still ‘way too high’, there is a feeling that monetary policy is leaving a mark. This is good news as a perception that the central bank cannot tackle inflation rates would be disastrous.

A rocky ride can be expected in the coming months as central banks confirm they will continue to tighten, dampening economic growth. Fiscal policies must be in step too. In other words, they must be capable of supporting demand and the country’s citizens in ways that do not interfere with the central banks that need to bring demand down to prevent prices spiralling.

Seventh, consumer confidence started to rise in October 2022, but it is still very low. Growing wages and almost full employment should boost confidence further. In contrast, business confidence remained depressed in December. Order books may still be full for companies around the world, but they are contracting versus previous peaks.

Risks remain

Even though outlooks have improved, substantial risks capable of derailing economies remain. First, there is the risk that the war in Ukraine will escalate. President Putin and his senior staff have made it clear that a nuclear power cannot be defeated and that victory is central to the existence of Russia.

While this is rhetoric and propaganda, there looks to be a real possibility that the war will continue for longer. The direct impact on global economies appears to be contained at present. However, this is tied to Russia’s current inability to progress further and for Ukraine, with support from its allies, to hold ground.

Inflation may not deflate as quickly as expected, i.e. back down to around 2% during 2024 in the Euro region. This would drive more stringent, longer-lasting policy tightening, which could turn economic growth into recession.

Labour markets are also exceptionally tight at present. Should that change, private consumption would fall, making a recession more likely.

Rising demand for energy in China, as the zero-COVID strategy lifts, may propel energy prices upward again. The country could shift to coal to satisfy the demand for cheap energy, which would be bad news for climate change.

A significant threat to global economies is the rise of protectionism, which could ultimately end in trade wars. The United States Inflation Reduction Act (IRA) is an example of this. Although economies seek to become more self-supporting along the value chains, this desire should not hinder the formation of an intertwined global economy. Without it, continued economic growth is at risk.

Improved outlooks may prove to be fragile and downside risks outweigh the chance of more positive developments. Yet, economies have proven to be more resilient than analysts anticipated a few months ago so cautious optimism is appropriate.