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Half full or half empty?

Headline inflation has peaked, but interest rates will stay elevated. The expected economic downturn will be milder than previously expected. However, the trough in property markets has not been reached yet. Among the Nordics, Sweden is the most vulnerable because of high indebtedness.

Klas Eklund, Senior Economist, Mannheimer Swartling

Central banks still in tightening mode

The global economy has been hit by severe shocks in recent years. Now, however, the outlook is gradually improving – but in uneven and uncertain ways. Headline inflation has peaked in the US and in the Euro zone. However, core inflation remains far above central banks targets, as inflation has spread to more goods and services. The labour market has remained surprisingly strong, particularly in the US, which is seen as an outstanding inflation risk.

Future inflation and monetary policy paths are uncertain. The Russian war of attrition may escalate with dangerous implications. The base case is nonetheless that headline inflation in most countries will come down sharply this year, courtesy of base effects and cooling economies. But central banks will keep monetary policy tight until they are convinced that core inflationary pressures are defeated longterm.

Thus, the Fed will continue with a couple of small hikes and likely keep its key rate at a high level for the rest of this year. The ECB and the BoE will also hike more. As a result, the present rate hike cycle will be one of the strongest in modern times.

The tightness of policy is actually more pronounced than indicated by interest rates alone, since central banks also are unloading some of the bonds they took on during the period of QE.

This holds for the ECB – i.e Finland and the Baltic countries – and for the independent national central banks of Scandinavia as well. As a result, Nordic property markets in general have not seen the trough yet. They will continue down until markets are convinced that rates have peaked and the next step is down.

A mild recession

The tightening of monetary policy will have negative effects on growth and employment – which is exactly what policy makers want, in order to cool the economy. Even though we have not yet seen the full effects of the tightening process, the downturn is seeming to become milder than previously anticipated.

In Europe, the main reason is that the economic fallout from the Russian invasion in Ukraine has been less harmful than projected. In particular, energy prices have not skyrocketed as expected. Gas and electricity prices are high, but much less so than forward prices indicated last fall.

Still, a recession is likely. Household demand is falling, and tighter monetary policy will exert a drag on activity also in the coming months. External demand is likely to be weak as the US and UK fall into recession. China’s growth prospects have improved and will marginally improve Europe’s outlook. But the Chinese uptick will be led by the services sector and will not have the same strong stimulative effect on the Western economies that it used to have. An obvious source of uncertainty in Europe is the development of the war in Ukraine – and the effects of an escalation.

Even when a possible recession ends, growth may be weak. Central banks will not go back to the experiment with ultra-loose policy. On the contrary, they may keep rates slightly higher than neutral since long-term inflation may stay higher than targets (see box to the right). Fiscal policy will also need to be more disciplined after large deficits for several years. Last year’s turbulence in the UK, where the “mini-budget” led to sharply rising bond yields, was a warning. While gas prices have fallen recently, they will remain well above pre-Covid levels – and the costs of energy transformation will be huge.

The forces determining economic developments on the European continent dominate also the Nordic and Baltic area. The Baltics show higher inflation and are more vulnerable to the Russian threat, but nonetheless they will perform better than the Nordics after a brief dip in H1. Sweden, Norway and to some extent Denmark are suffering from overstretched property markets.

Financial markets

Global equities have rallied as markets expect central banks to reach the key rate peaks soon; they prefer to look beyond the tightening cycle and instead focus on the upturn which will come later. The same optimism seems to have caught the bond markets. At the beginning of 2023, prospects of falling inflation caused bond yields to come down from the peaks last autumn.

However, there is a clear risk that markets have been moving too fast – as they did several times last year. The tug-of-war with hawkish central banks is far from over. Both the Fed and the ECB have signaled more than one additional rate hike. This suggests a bumpy ride for some time yet, as new rate hikes will make investors worry again, from time to time.

So, inflation will come down in 2023. But then what? There are several reasons to believe the “new normal” inflation rate is higher than in the last decade. China is not exporting deflation anymore. Globalization is retreating somewhat, due to protectionism, industrial policy and shortening of value chains. This will slow down productivity growth and consequently costs will rise. The greening of the economy will also cause cost increases in the medium term. The IMF has estimated that “greenflation” may add another 0.3-1.2 percentage points yearly to global inflation. Without making any precise forecast, my guess is that the new “normal” level of inflation will be 3 rather than 2 per cent.

Neutral interest rates are, consequently, also on the rise again. The nominal rate will increase due to inflation, but it is also possible to make a case for rising real rates. The global neutral rate has been trending down in recent decades. Important factors were slow productivity growth and an aging population with increasing propensity to save.

But now, China’s population has stopped growing and is starting to shrink. To some extent this may be balanced by increased savings in countries like India, Nigeria and Indonesia, but for the foreseeable future the net effect is that a savings glut will weaken. At the same time, increasing public debt may eat into savings. Increasing investments in energy transition will increase demand for capital. As a consequence, markets' views of long-term real interest rates have shifted up by almost 2 percentage points in the past year. A common view among forecasters, as collected by Svenska Handelsbanken, is that neutral nominal policy rates in the new normal will be around 2.5% for the US and the UK, 2–2.5% for Sweden and 1.5–2% for the Euro zone.

So, once we are out of the pandemic and war shocks, in the “new normal” central banks may face both higher inflation and higher neutral rates. This means that the extremely low nominal rates of the 2010s will not return. Hopefully, in this situation the central banks will relax their monetary policy framework rather than use overly tight rates to press down inflation below its new normal. The same conclusion can be drawn from the failed experiment with ultra-loose policy: when strong global forces move the neutral rate, central banks should allow more flexibility rather than apply strict inflation targets.

The Nordics and Baltics

In recent years, Norway, Sweden and Denmark have all been strong-performing economies, while Finland have seen slower growth. Now, this trend is somewhat reversed: all countries are hit by rising inflation and rates, but the fallback is relatively mild in Finland while Sweden in particular suffers from high leverage and household indebtedness. House prices have fallen sharply in Sweden and Norway and private consumption has been reduced after several good years.

The Baltics have been growing rapidly during a period of catch-up. However, they were severely hit by higher energy prices, bottlenecks and geopolitical tensions after Russia’s invasion of Ukraine. The effect has been very high inflation – in the 20s in all three countries – which sharply has cut into real disposable income. Since interest rates are set by the ECB from the perspective of the entire monetary union, the result has on a national level been a loose monetary policy. This year inflation will fall rapidly in all three countries, despite high wage increases. House prices will fall and H1 will see a rather mild recession, moderated by low levels of private indebtedness. An upturn will begin in H2 of 2023.

Sweden

After economic resilience last year, 2023 began with falling GDP. This year’s decline will be clearly harsher than the EU average. Important drivers are falling real incomes and a brutal downturn in housing construction. High inflation will lead the Riksbank to hike its key interest rate at least once more, before cuts begin in 2024. Tighter monetary policy hurts Swedish households more than in most other countries, since mortgage debt is of short maturity. Fiscal policy has been tight, compared to other European countries, and government debt is projected to fall further. However, it is likely that fiscal policy will be loosened during 2023, with tax cuts and higher expenditure at the same time.

The Swedish krona has been falling precipitously, as it is regarded as unstable in turbulent times. The Riksbank’s previous low-rate policy also contributed to a weak currency. The new Riksbank governor has, however, clearly stated that he sees the weak krona as a problem and that he wants it to strengthen. One measure will be to unload some the central bank bond portfolio which also will slow down the projected fall of bond yields.

Home prices will continue to fall. Home prices had fallen by almost 15 per cent from the peak by year end. They will continue to fall during H1 2023. The consensus view is that the overall home price downturn will reach 20 per cent. The average interest rate on a home mortgage loan with a three-month fixed interest will triple during 2022-23. Interest expenses will increase from 2.5 per cent to an estimated 5.5 per cent of household incomes, as a result of many households having short-term debt.

Norway

Growth in mainland GDP has held up well, but economic activity indicators still point to stagnation ahead. Households will be able to sustain their high level of consumption only by depleting some of their savings. Cautious businesses will weigh on mainland investments. The labour market is still tight, but unemployment will rise slightly, from low levels. Despite the slowdown, Norway will probably record positive growth in 2023, the only country in the region to achieve that, courtesy of swift increases in energy investments.

Inflation is still high; both headline inflation and the target measure of Norges Bank reached new peaks in January 2023. A further hike is expected this spring, but the Bank has signalled “a more gradual approach” to rate setting, meaning that further hikes will be small. the current account surplus puts pressure on the currency. Thus, the Danish central bank may need to keep its key rate slightly lower than the ECB; the spread, however, will still be small, within the set trading range.

Home prices rose in H1 2022, but prices have fallen recently in the wake of rate hikes. Although the sector has been quite resilient, the outlook for 2023 is weaker, since tighter money probably has not fed through the system yet. Higher mortgage rates, restrictive bank lending and expectations of home price declines are weighing on housing demand, which indicates price decline in the near term. Analysts expect a 10 per cent peak-to-trough fall, with prices bottoming out around sumenmer.

Construction activity has fallen, putting downward pressure on housing investment, which will see sharp declines in H1 2023. Higher interest rates and tighter credit caused a decline in real estate transactions in late 2022. After several years of hefty growth, prices of both houses and apartments have fallen and will continue to do so during 2023. But the level of household debt has decreased after many households refinanced long-term mortgage loans to reduce their debt. This should make the Danish market less vulnerable than the Swedish. A recovery can be expected in 2024, at the latest.

Finland

Denmark

After several years of strong performance, Denmark’s GDP weakened in Q4 2022 due to high energy prices and falling private consumption. H1 2023 looks to be weak as well, with falling real wages, lower home prices and tighter credit conditions. Consumer confidence fell sharply in the fall and has not recovered yet. As a prominent shipping nation, Denmark profited from high freight rates during the pandemic, but as freight rates fell last year exports took a hit.

Headline inflation will gradually fall, but as with her neighbours, Denmark’s core inflation has not peaked yet. Denmark’s krone is tied to the euro, but

The Finnish economy has withstood the shocks fairly well. Last year, goods export rose despite a complete stop in trade with neighbouring Russia. Consumer sentiment has fallen, though, and as export orders fall, the economy will go through a shallow recession during H1 2023. Employment will weaken. Investments were strong in 2022, but business is becoming more cautious. Growth will gradually pick up again in H2, as lower inflation will lift private consumption. For the year 2023 as a whole, GDP growth will be more or less zero. In 2024 a modest growth rate will be recorded.

Residential investment rose in 2022. As in Sweden, the Finnish housing market is cooling, but the declines in prices and transactions have not been as steep. Household indebtedness is not as high as in Sweden. Since the upswing in the housing market was less frenzied than in the rest of Nordics, the downturn will now be softer.

Estonia

GDP fell in H2 2022 and the fall will continue in H1 2023. The economy is hurt by the downturn in Sweden, as wood processing and exports such as prefabricated houses and furniture have fallen. The labour market is in good shape, with strong wage growth, making domestic consumption resilient. Inflation will fall from some 20 per cent in 2022 to around 10 per cent this year, still probably the highest in the region. Estonia is expected to return to positive growth during H2, supported by resilience in domestic demand and improving exports.

The housing market is decelerating. Apartment sales in Tallinn are falling. However, a large drop in prices will probably be avoided since real estate developers are well capitalised compared to Sweden. Furthermore, household indebtedness in Estonia remains far below the levels seen in the Nordic countries, making it less vulnerable to rising interest rates.

Latvia

The economy is entering a recession which will reach bottom in H1 2023; during H2 an upturn will commence. For the year as a whole, GDP growth will hover around zero. Exports have been surprisingly strong, as trade with Russia has gradually been replaced by trade with Western Europe. But a downturn started in late 2022, and will continue during 2023. Consumption faces headwinds as disposable income shrinks. A rise of the minimum wage will, however, hold up wage increases and alleviate inflationary pressures on households. Falling energy prices will eventually cause high inflation to slow, but from a very high level. Receding inflation should eventually help consumption. Energy disruption and geopolitical risks will remain threats.

The real estate market has weakened during winter; home prices have fallen, and some segments will face price decreases of 5–10 per cent. The fall will probably be smaller than in the other Baltic countries since price growth in recent years has been moderate.

Lithuania

Strong exports helped the economy in 2022, but lower exports will lead to a brief recession in early 2023. GDP growth will remain just above zero for the calendar year, helped by EU funds. Manufacturing has weak ened. Private consumption growth will remain negative for some time, but will gradually strengthen in H2 as inflation falls. The labour market has been strong, partly because of net immigration; but this year employment will fall. Inflation peaked in the fall of 2022 and will fall this year, but rapidly rising wages will mean rising costs in several sectors. A great challenge is to in tegrate the flow of refugees from Ukraine.

The housing market weakened in late 2022; the number of transactions dropped. After previous rises, property prices will face a decline in the first half of 2023, as interest rates will continue to rise.

Conclusion

The European economy is at a crossroads – again. Core inflation is still high, and even when it comes down, the ECB will keep rates high for a protracted period to root it out. The effect will be an economic slowdown, but as energy prices have come down significantly, it will probably be mild – unless an escalation of the war in Ukraine will create havoc. The ECB is squeezed between real economic weakness and high inflation. The same goes for the independent central banks in Norway and Sweden.

Property markets are still falling. We may have to see the interest rate peak before they bottom out and start to rise again. Some sectors – retail – and companies – in particular highly leveraged developers –will encounter problems.

So is the glass half full or half empty? It is half full when it comes to the general economic situation, which is better than anticipated half a year ago. But as regards to the property market, it is still half empty.