Euro area: Challenging long-held assumptions

We believe 2022 will be the year when macroeconomic and political developments challenge two deep-rooted misperceptions about the euro area:

• Market assumption 1: the euro area cannot inflate. Our expectation: core inflation will persistently surprise on the upside in 2022.
  
• Market assumption 2: the euro area faces persistent structural headwinds. Our expectation: the structural risks of a break-up have faded.

Upside inflation risks

The notion that the euro area is a region of inherently low inflation really took hold after the global financial crisis and was reinforced during the European sovereign debt crisis. In stark contrast to then, monetary policy is currently exceptionally loose, while plans to rein in the pandemic-related fiscal stimulus are far more moderate. At the same time, there is significant pent-up consumer demand, and the industrial cycle should bottom out in the spring. As a result, we think growth through 2022 will probably be even higher than the consensus expectation of 4.5%, taking GDP back to its pre-COVID trend level by the second half of 2022, a year earlier than forecast by the European Central Bank (ECB).

Moreover, largely unnoticed by the market, the euro-area labour market has been improving rapidly, with employment back to pre-pandemic levels. And our indicator of labour demand is at its highest for over two decades. The likely upshot: a strong increase in wage growth later this year and above-target inflation, with headline CPI at 3.8% (above the ECB’s forecast of 3.2%) and core at 2.3% (versus 1.9%).

Yet the near-term outlook is for a weak GDP number for the first quarter, as the economy feels the impact of the Omicron variant. So, at its March meeting, the ECB may dismiss the rise in inflation and the strength in the jobs market. After all, in December the ECB said it was “very unlikely” to raise rates in 2022, and the market is largely taking this at face value.

But that was a probability, not a commitment, and we think the ECB will be forced to change its tune later this year. In fact, we see a strong probability of an end to quantitative easing in September and a better-than-even chance of a rate hike by the fourth quarter.

Fading break-up risks

The euro area continues to face demographic headwinds. In addition, we have the uncertainty of upcoming elections in Italy and France, though we view victories for the extremist candidates, Matteo Salvini and Marine Le Pen, very much as tail risks.

Nevertheless, we see a significant improvement in the underlying structure of the euro area, with real progress towards a proper currency union. In our view, this could be a game changer, which markets haven’t fully appreciated.

Crucially, the new German coalition is providing the euro area with the most significant opportunity yet for a structural shift in attitudes. We think this raises the probability of greater burden sharing across the euro area, with the recovery fund becoming permanent and an acceleration of moves to a full banking union and bloc-wide deposit insurance. 

In addition, the new German government’s policy is more tilted towards growth and investment. As well as being more flexible on the Stability and Growth Pact, the coalition seems prepared to accept higher inflation — witness the recent steep rise in German core CPI.

Some improvements predate the coalition. Since the global financial crisis, Germany’s competitiveness gap versus its euro-area competitors has been steadily eroded as its unit labour costs have increased.

While these are all relatively slow-moving dynamics, we look to the revision of the German budget (due in the first quarter) as an early indicator of this change in fiscal attitudes, which is an essential condition for closer union.

Conclusion

We believe that both inflation and growth in the euro area could surprise on the upside after the second quarter of this year, and we see concrete signs of an improving structural story. We think that will test two deep-rooted assumptions about the euro area: that it can’t inflate; and that it is a structurally challenged currency bloc. We expect the market to revise up its rate expectations for the ECB, and we see scope for the euro to strengthen relative to the dollar and sterling. An improving structural story could also support European equities on a relative basis.