Risks of recession in the global economy are increasing

Energy crisis in Europe, Russia's invasion of Ukraine, soaring interest rates, instability in financial markets, high inflation and declining purchasing power, zero COVID-19 strategy and struggles in the real estate sector in China, as well as the normalization of the consumption structure after the end of COVID-19 pandemic, are increasingly impacting global economic growth. As a result International Monetary Fund (IMF) has once again cut its 2023 global economic forecast from 2.9% in July 2022 to 2.7% now. This is a very significant drop in global economic growth after 6% growth in 2021. With exception of the first year of the COVID-19 pandemic in 2020, in 2023 the world economy is expected to experience the slowest GDP growth since 2009. However, risks are still tilted the downside and the IMF has also warned that the worst is yet to come. At the same time, both in the World and in the Baltics, the actual economic situation is still quite good, and the deterioration is mostly visible only in sentiment indicators. However, recession risks are also high in our region in the next 6 to 12 months.

In euro area inflation has reached 10% and in the Baltics the price increase has even exceeded 20%, while in the world as a whole inflation will be close to 9% in 2022, which is the highest level of global inflation since 1996. The rapid rise in natural resource prices remains the main driver of inflation, but in order to prevent un-anchoring of inflation expectations and a wage-price spiral formation, central banks have begun to rapidly increase interest rates. In the US Fed funds rate has exceeded 3%, while the 6-month Euribor rate in the eurozone has reached 2% and, according to the financial market, could approach 3%. At the same time, there are quite a lot of signs that the peak of inflation is close and inflation in the world is likely to begin to decrease in the coming months. The pandemic period of goods shortages is over – inventory levels have recovered and new orders in global industry have begun to decline, while container shipping costs between China, the US and Europe have shrunk by almost 80% from their peak late last year. Also, since May, the world prices of food, metals, and oil have decreased by almost 20%. Meanwhile, world food prices have decreased by almost 14% since April. However, lower inflation and risks of recession may not automatically mean a cut in interest rates, as cut rates too quickly could again trigger a new wave of inflation after the impending recession is over.

European countries have managed to prepare for winter faster than planned and gas storages have exceeded 90% already in mid-October, even despite the suspension of Russian supplies and the sabotage of Nordstream gas pipelines. Full natural gas storage and a warm autumn have dampened immediate demand, and Europe has succeeded in replacing Russian gas with other sources. As a result, natural gas prices in Europe have fallen below 150 euros per megawatt hour from more than 300 euros at the end of August. However, even full natural gas storages cannot ensure Europe's winter gas consumption, and Europe's energy situation will depend on import flows, so interruptions in energy supplies cannot be completely ruled out. Likewise, without Russian gas, it will not be easy to ensure a sufficient amount of natural gas reserves for 2023/2024 because the amount of liquefied gas available on the global market may not be sufficient to compensate European imports from Russia.

Due to the energy crisis, the threat of recession is higher in Europe than, for example, in the United States. Although the risk of an energy shortage has eased, it is not completely ruled out and inflation, which has exceeded 10%, forces the ECB to raise interest rates even in a situation where economic growth is already weakening. In September, consumer sentiment in the eurozone fell to historic lows, even below the 2008 and 2020 lows, Germany's consumer intentions to make large purchases are falling sharply, and German business prospects have also fallen below 2008 levels. At the same time, inflation in Europe is still 10% and the rise in interest rates is beginning to limit countries' opportunities to support their economies, which was clearly demonstrated by the very negative financial market reaction to Britain's plans to reduce taxes at the expense of additional borrowing.

However, signs of economic slowdown are visible and GDP growth has started to slow down in the 2nd quarter of 2022. In the 2nd quarter, Latvia's GDP grew by 2.9% compared to the previous year, in Lithuania GDP increased by 2.6% and in Estonia by only 0.6%. Since February 2022 business and consumer sentiment in the Baltics has noticeably worsened and consumer sentiment has fallen to the level that was last observed at the beginning of the Covid-19 pandemic. However, industrial output and retail sales volumes have increased, the labor market remains strong and credit continues to grow in the Baltics, although an unprecedented gap has developed between negative consumer sentiment and growing wages and retail sales.

In euro terms, retail turnover in August in all three Baltic countries increased by almost 20% compared to the previous year. However, this has largely happened due to inflation and the decline in purchasing power is becoming more and more noticeable. In August, the physical turnover of retail trade, excluding inflation, only slightly increased in Latvia and Estonia, while the physical volumes of retail sales decreased slightly in Lithuania. Consumer sentiment in the Baltics, as well as in the Eurozone, is currently only slightly better than in 2009, and the high prices of energy resources in the winter months will worsen the financial situation of households. In fact, we can already see the deterioration of the financial situation of households right now, before receiving the heating bills. Household deposits in banks in the Baltics are no longer growing, retail sales are growing faster than wages, and consumer loans have also started to grow. Currently, inflation in the Baltics has exceeded 20% and continues to grow, but the peak of inflation is expected in the coming months and inflation should begin to decrease at the beginning of next year.

In Europe, high energy prices are already forcing energy-intensive companies to stop or limit production. At the same time new industrial orders are decreasing worldwide, while inventory levels, which during the COVID-19 pandemic decreased significantly and a deficits appeared in many places, have now significantly rebounded. Weaker external demand is already felt in the Baltics as well. In August, in Latvia and Estonia, production volumes in industry decreased by 1.2-3.7% compared to the previous year, and although strong growth continued in Lithuania, new industrial orders are decreasing in all Baltic countries. According to data published by Nordpool, electricity consumption in the Baltics has decreased by 5-10% in September and October compared to the previous year. Of course, the high prices encourage energy saving, and at the same time, the production of electricity for own use with solar panels is growing rapidly. But that likely doesn't explain the entire decline in consumption; rather, this is a signal of a further decrease in industrial activity. In addition to that, the fall in purchasing power caused by inflation will be felt not only in the Baltics and it will mean less consumption of industrial goods, as well as declining activity in construction. For example, lumber prices in the US have already returned to pre-pandemic levels. This, together with the energy crisis in Europe, suggests that production volumes in the Baltic industry could decrease in 2023.

Although lending in the Baltic States remains strong and real estate prices continue to rise, construction sectors does shows signs of a slowdown. Compared to the previous year, in the 2nd quarter of 2022, the physical volumes of construction in Latvia and Estonia decreased by 13.7% and 1.4%, respectively, while in Lithuania the volumes of construction increased by only 1.4%. The rapid rise in prices and the uncertainty caused by the Russian invasion of Ukraine have stopped the implementation of certain projects. At the same time, due to inflation, interest rates have also started to rise and the 6-month Euribor rate, which was 0% at the beginning of June, has now reached 2%. For the time being, we do not see very big changes in the Baltic real estate market, because the rate increase has only just happened and the economic situation in general is still good. However, higher interest rates will reduce the amount of mortgage credit available and will have an impact on the real estate market. In addition more than 90% of mortgage loans in the Baltics have variable rates, so the increase in interest rates will affect not only new buyers, but also people who already have mortgage loans. However, bank lending in the Baltics has been quite cautious in recent years, and the debt level in our region is one of the lowest in Europe. The number of real estate transactions in the Baltics has decreased slightly this year, and the prices of apartments in Soviet-era serial projects have started to decrease in Latvia. Combination of rising construction prices and interest rates will slow down activity in the real estate market, as well as in construction. However, there is probably no reason for a large drop, as the ratio of real estate prices to income in the Baltic States is at a fairly reasonable level, and subdued private sector activity in construction in the coming years will be partially offset by the expected inflow of funds from EU economic recovery fund into the economy.

The unemployment rate in the Baltic countries continues to decrease, and in Lithuania, as well as in Latvia, unemployment has fallen to pre-pandemic levels at the end of 2019, and unemployment in the Baltics is currently in the range of 5.2% to 6.5%. At the same time, wages continue to grow by about 10% per year, but this year the price increase significantly outstrips income growth. As a result, the purchasing power of citizens decreases, deposits in banks no longer grow, citizens begin to use the savings created during COVID-19 and consumer loans grow. High inflation will certainly create additional pressure to raise wages, but in the last 10 years link between wage growth and inflation has not been very strong, and the great uncertainty about economic outlook could slightly dampen wage growth. Slower economic growth is also visible in the somewhat smaller number of job advertisements, but there are no big changes in the labor market yet. Of course, the labor market reflects trends in the economy only with a delay and the situation can change.

The good news is that the domestic economy of the Baltic region is strong: debt levels are low, the financial system is stable and the real estate market shows no obvious signs of significant overheating. Therefore, this is not going to be repeat of the 2008 crisis. However economy is expected to decelerate in the coming months. New industrial orders are already falling, high food and energy prices are reducing consumer purchasing power. This will affect trade and service sectors. Also, the situation in the labor market is gradually starting to deteriorate, so the next 6 to 12 months will be difficult in the Baltic economy, and next year, overall GDP in the Baltic countries could decrease by 0.2% to 0.6%. Inflation will also decline next year, but the situation in the energy market is likely to remain very tight also in the next winter and financial market expect natural gas prices to remain high until 2025. High inflation and rising interest rates mean that governments fiscal space is tighter than it was at the start of the COVID-19 pandemic. The time when countries could borrow at very low or even zero interest rates is over, and borrowing rates have already increased significantly, while financial markets are looking carefully at the actions of governments. For example, United Kingdom’s recent attempts to support the economy have led to a sharp drop in the exchange rate and a rise in interest rates, and posed a risk to financial stability. And the fundamental solution to the energy crisis is not subsidies for consumption, which are needed in the short term, but investments in energy efficiency, production of renewable resources and gas import infrastructure.