Mid-summer blues

Key points:

• The US is not yet in a “proper recession” - yet. The labour market is key there, and the Fed will want to see clear signs of deceleration in wages before lowering its guard.
• The Euro area’s Q2 upside surprise is fragile. At 20% of capacity, the flows of gas through Nord Stream 1 create a massive risk, raising key questions for the ECB. 

With US GDP falling in Q2 for a second quarter in a row, discussions on the definition of recessions have been rife. Our view is quite simple: while indeed, the sources of contraction in 1H 2022 may be too narrow to qualify as a “proper recession”, underlying signals – in particular fading support from consumption – are concerning. Yet, significant job losses should be a key ingredient in a recession. This is missing for now – despite some early signals from jobless claims. This is key for the Fed. They have not given up on the neo-Keynesian approach. The FOMC still believes in the Phillips curve, and they want to see a deterioration in the labour market trigger a deceleration in wage growth. This will make the next few payroll prints crucial, possibly leading to significant volatility. While the market has for now decided to look through the Fed’s tightening phase, the Fed won’t want to lower its guard easily.

A stronger than expected GDP in Q2 in the Euro area came out in sharp contrast with the US. Still, the details of the upside surprise suggests that the underlying position of the Euro area remains extremely fragile. The post-reopening catch-up started later in Europe than in the US. Once this effect dissipates, we expect GDP to contract in the Euro area as well, the depth of it depending on the quantum of Russian gas flowing to the EU. In our calculations, if Russia maintains the flow of gas through Nord Stream 1 at 20% of capacity, Germany and Italy would not be able to go through the winter without rationing, the quantum of which – and hence of the associated recession – would depend on some resource-pooling at the EU level. Unfortunately, the 20% trickle may be the optimal level from Moscow’s point of view, allowing Russia to retain massive pressure on the West and decent hard currency receipts given the rise in prices. The behaviour of the ECB in a recession triggered by gas rationing would be key. For now, it seems their natural slope would be to hike further. It may take time for the hawkish rhetoric to be toned down, but the market is impatient.