HUP: Recovery of Germany is expected in the second half of the year as well as the first cut in ECB interest rates

It is increasingly certain that Germany will gradually recover in the second half of the year thanks to strengthening prospects for the global production cycle and the easing of unfavorable euro movements. In addition, the dampening effect of rising ECB reference interest rates is diminishing, and the first cut in ECB interest rates is expected by mid-year, writes HUP in its analysis.

Thanks to falling energy prices in the coming months, at least stabilization is expected in energy-intensive sectors, following a nearly 20 percent drop recorded over the last two years. It is possible that parts of the production of intermediate goods could become profitable again, but some capacity has already moved to markets with cheaper energy sources. However, Germany continues to suffer from a loss of competitiveness, especially due to expensive energy – prices are 10 percent higher than the EU average, double the prices before the Russian aggression against Ukraine, and even 3.5 times higher than energy prices in the U.S.

The quality of business in Germany has been deteriorating for years due to an outdated transport network, lengthy procedures for issuing business permits, educational standards, and high taxes. Even worse, the automotive industry, which is the flagship of the German economy, is lagging in the transition to electric vehicles and is increasingly affected by Chinese competition. The rise in real wages, buoyed by generous collective agreements, supports personal consumption, but despite this, consumption levels have significantly underperformed expectations over the last two years. However, in the second half of this year, and especially in 2025, there is hope that the German economy will emerge from the stagnation it has been battling for five years.

– In 2025, we expect German GDP to grow by only 0.5 percent after two consecutive years of decline of 0.3 percent – writes HUP.

After a strong acceleration in growth in the second half of 2023 at a rate higher than 3.5 percent on the back of a robust labor market, the growth of the U.S. economy is slowing in the first half of this year to below two percent under the burden of high interest rates, diminishing fiscal policy support, and underperformance in personal consumption. The economy there will accelerate its growth rate again in the second half of the year to above 2 percent.

– In support of our thesis, Fed indicators of financing conditions show improvement, which typically first manifests through a drop in interest rates for the construction sector and a recovery in real estate investments. The labor market recovery continues, along with a strong pace of investments in new factory capacities with ongoing ‘onshoring’ of production from geopolitically sensitive locations (China), and the strong growth of investments by companies outside the construction sector in recent years will have positive implications for productivity in the medium term. Therefore, in 2024, we expect sustained growth in personal consumption and investments in capital goods, so we have raised our forecast for U.S. economic growth to 2.5 percent (previously 1.5 percent) after 2.5 percent in 2023 – note HUP.

ECB to lower deposit rate to three percent by spring 2025.

It is likely that the overall inflation rate will drop to 3 percent instead of the targeted 2 percent. The expected slowdown in U.S. PCE inflation to 2.7 percent (on average) this year, after 3.7 percent last year, is largely a result of base effects and stabilization or decline in prices of higher energy sources. Price risks are directed upwards, particularly due to wage growth, which, despite the slowdown, is stronger than before the pandemic and is a strong driver of service prices.

– If there is no significant slowdown in the economy, strong wage growth could prevent the stabilization of inflation at a rate of around two percent. Structural factors, such as protectionism and a decreasing labor-active population, also contribute to inflation. On the other hand, the technological revolution in the U.S. and the rise in productivity significantly contribute to stabilizing labor costs, which acts deflationary in the medium term, and this circumstance is insufficiently publicly recognized. Assuming a labor cost growth of around 4 percent in the coming years and a productivity growth of 1.5-2.0 percent, we expect inflation to stabilize within 2.0-2.5 percent – writes HUP.

In the euro area this year, HUP expects a fall in the average inflation rate to 2.3 percent (on average) from last year’s 5.5 percent due to an extended period of stagnant aggregate demand and the easing of remaining supply-side constraints. In the first half of the year, particularly further declines in inflation for food products and industrial goods support this, but strong growth in collectively negotiated wages of 4-5 percent annually, against negligible shifts in productivity, again drives up service prices in the second half of the year.

A major unknown is to what extent the withdrawal of measures taken by national authorities to curb energy, food, and rent prices will affect inflation movements. Structural factors, such as protectionism, a decreasing labor-active population, and the costs of energy transition, also contribute to inflation. Therefore, it is more likely that the overall inflation rate will stabilize at around 3 percent rather than around 2 percent, and the average core inflation (2.7 percent) will remain significantly above the ECB’s target level of 2 percent.

And while the renewed development of inflation in the U.S. shifts the timing of the Fed’s interest rate cuts towards the end of this year, aggregate demand in the euro area is weaker, so the ECB is expected to start cutting rates in mid-2024 at a pace of 25 basis points quarterly. In the case of the ECB, this involves reducing the deposit interest rate from the current 4.0 percent to 3.0 percent by spring 2025. Expecting stabilization of core inflation at around 3 percent instead of the targeted 2 percent, in the base scenario we do not expect further rate cuts after spring next year, unlike futures markets and mainstream economists.

– Furthermore, we do not expect the ECB to actively sell bonds – neither as part of the main asset purchase program (APP) nor within the pandemic program (PEPP). Instead, the ECB could ‘build’ a portfolio of structural securities as part of its new monetary strategy from 2027 onwards – conclude HUP.