- Head of Multi-Asset Strategy – EMEA
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In their recent paper, What next for the euro area after the ECB’s historic hike?, my colleagues Eoin O’Callaghan and Marco Giordano assessed the potential future path of euro-area inflation and growth in today’s challenging environment. Here, I examine the European Central Bank’s (ECB’s) difficult policy choices and discuss asset allocation amid the uncertain macroeconomic and policy backdrop.
We think euro-area headline inflation could be reaching its peak in September, but investors should, in our view, brace themselves for inflation to remain elevated and more volatile for the next 12 to 18 months. Longer term, we anticipate the region’s headline and core inflation will stay above the ECB’s target levels, with wage growth a key structural driver of core inflation. We see similar dynamics at work elsewhere in Europe, with the UK being particularly vulnerable to labour shortages and high levels of imported inflation.
In this environment of persistent inflation, ECB policymakers are facing a significant challenge, having to tighten policy despite slowing growth and at a time when Europe is facing the full brunt of spiralling energy prices. The loss in value of the euro relative to the US dollar is further fuelling price rises. The ECB has few tools to respond to this imported inflation. It must also deal with renewed dispersion risk between core and periphery countries and, crucially, the risk of an energy shock if Russia were to cut off gas supplies this winter. While we think a total shutdown of Russian gas supplies would be unlikely at this stage, ongoing disruption is probable, leading to meaningfully lower growth and higher headline inflation.
Given this backdrop, we think investors need to proceed with caution and we have shifted our asset allocation to reflect the euro area’s inflationary and slow-growth environment and the resulting challenging policy backdrop.
In fixed income, we are neutral European duration and have an overall neutral position in global defensive fixed income. We are underweight higher-risk credit, which we view as vulnerable to spread widening in a slowing economy. Although the structural nature of euro-area inflation makes it unlikely that the ECB will abandon its rate-hiking cycle, a scenario in which inflation stays at around 3% – 4% and growth remains under pressure would test the ECB's resolve. The potential for political instability is another source of risk, as illustrated by the spread widening between Italian government bonds and German bunds that followed the collapse of the Italian coalition government led by Prime Minister Mario Draghi. While we believe that ECB policymakers will use their recently agreed Transmission Protection Instrument to prevent a disorderly widening in spreads beyond the level justified by fundamentals, it still is a further source of uncertainty for investors.
Within our active asset allocation framework, we are moderately underweight global equities, with a more cautious stance on European equities. Our view on European equities stems largely from the persistence of high inflation and the ongoing impact on earnings and multiples of the reversal of accommodative monetary and fiscal policy. While fiscal expansion helped the euro area and most other European economies bounce back rapidly from the pandemic, the region is facing challenges in the short to medium term, having to contend with higher inflation and the disruption stemming from the intensifying energy shortage. Industrial companies would be first in line to potentially face energy rationing if this acute scenario persists. Some growth drivers remain in place, given Europe’s tight labour market and fiscal policy that is more supportive than in most other developed markets. However, serious disruption to energy supplies has the potential to offset any positive impact from these factors.
For European equities, higher and more volatile inflation is increasing pressure on margins and driving up earnings risk. Relative to other developed economies, Europe is more exposed to the global cycle and a more fragile growth backdrop, and companies in the euro area and beyond face significant costs and uncertainty as they navigate this environment. The market’s expectation is that earnings will grow by 7.2% over the next 12 months, with the region still seeing an even balance of analyst earnings upgrades and downgrades (Figure 1). The euro's depreciation should act as a tailwind for the region's exporters, but elevated currency volatility (alongside rising input prices) makes pricing decisions and planning through supply chains more complex. While pent-up demand and household cash buffers have enabled European companies to raise prices, this could become less feasible as inflation increasingly erodes consumers’ purchasing power. Moreover, some governments are trying to pass some of the burden of higher energy and interest costs to the private sector, as demonstrated by the recent windfall taxes on banks and utilities in Spain.
These challenging circumstances have already partly been reflected in euro-area equity valuations. At 7.95% (the MSCI EMU Index versus the 10-year yield on bunds as of 29 July 2022), the equity earnings yield relative to bond yields is at its widest level since March 2020 and is significantly higher than the 10-year average of 6.9%. However, if, as likely, earnings downgrades increase, it is reasonable to expect euro-area equities to slide further regardless of what happens to energy supplies. If Russian gas supplies to Europe were to be cut off almost completely, we would see a significant additional increase in the risk premium, particularly in energy-intensive sectors.
From a medium-term perspective (i.e., beyond the next 12 – 18 months) in particular, we still see a case for diversified exposure to commodities as structural inflationary pressures make us more positive on commodity-linked equities. However, volatility in commodity prices on the back of continued geopolitical turmoil and growing recession fears underscores the need to tread carefully. We also remain positive on infrastructure investments, whose revenue streams are linked to inflation. Where appropriate, we would also look at select exposures to long/short strategies that may help navigate market volatility as well as private market strategies that focus on new, innovation-led income streams with significant pricing power potential.
Figure 2 summarises our near-term key asset views. Over the long term, structurally higher inflation and increased government spending and investment should, in our opinion, lay the foundations for higher nominal growth and higher equilibrium yields (the short-term interest rate at which inflation is stable) in the euro area and beyond. Europe’s equity markets would benefit from a higher nominal growth environment given their higher operational leverage relative to US and other developed markets, making us more positive on the region beyond a 12- to 18-month horizon. At a sector level, this environment would favour financials and cyclical sectors as their revenues and profits would benefit from higher aggregate demand and interest rates.
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