SPEU - Europe: Sticky Inflation Favors Income

2023-03-06 12:15:00 ET

Summary

• We think improving euro area activity signals more rate hikes to come. We like short-term government bonds, high-quality credit and selected equity sectors.
• Data last week showed still-high euro area inflation and strong U.S. manufacturing activity. So we see central banks keeping rates higher for longer.
• This week’s U.S. jobs data will help gauge how tight the labor market remains, a key factor keeping core services inflation stubbornly high.

Transcript

European risk assets have outperformed this year. That’s partly because the energy crunch was milder than expected and export-oriented sectors including luxury goods look set to benefit from China’s restart.

But we don’t think this outperformance will last.

Here’s why:

1) Good news on growth bad for risk assets

Good news for growth now means the European Central Bank (ECB) has more work to do to cool inflation later. That’s a headwind to risk assets, in our view.

2) Policy rates to tip euro area into recession

We see policy rates already on track to cause a euro area recession this year. Data last week showing core inflation rose and services activity improved. This may push the ECB to hike more.

Markets are now expecting rates to peak higher and less rate cuts next year.

3) ECB to keep rates higher for longer

We expect the ECB to keep rates higher for longer until inflation falls to its 2% target and won’t cut rates before the second half of 2024.

Why? A tight labor market means that inflation won’t fall toward the policy target on its own.

Higher rates and persistent inflation boost the appeal of high-quality credit and short-term government bonds. We don’t think stocks are pricing in the economic damage we see ahead even as valuations in Europe look still comparatively inexpensive.

We underweight European stocks but like the financial, energy, healthcare and consumer discretionary sectors.

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European stocks have outperformed this year as China’s economy restarts and the energy shock proved less severe than expected. We don’t see the outperformance lasting: the market’s focus is shifting to sticky inflation due to firms upping wages to hire and retain staff. Good news on the economy means the European Central Bank (ECB) needs to hike rates more to cool inflation. We still expect a recession as higher rates kick in. We prefer short-term bonds for income.

Shifting expectations

Notes: The orange line shows peak or terminal ECB policy rate expectations based on futures prices. The pink line shows expectations for the end of 2024, the yellow line shows the actual path of the ECB deposit rate.

Euro area stocks have outperformed U.S. peers by about 14% in local currency terms since the end of September, MSCI index data shows. That’s partly because the economy has withstood the energy crunch even as the war in Ukraine drags on. Plus, export-centered sectors also look set to benefit from China’s restart. Yet, good news on growth now means the ECB has more work to do to cool inflation later, as we said for the U.S. We think that’s bad news for Europe’s risk assets. We see policy rates already on track to tip the economy into recession this year after growth stagnated at the end of 2022. Data last week showing core inflation rising and services activity improving may push the ECB to hike more. Market pricing now expects rates to peak around 3.9% (orange line in chart) versus about 3.2% in February, with fewer rate cuts seen in 2024 (pink line).

Europe’s cooling goods inflation and lower gas prices have driven a drop in overall inflation. We think elevated services inflation will prevent inflation from falling to the ECB’s 2% target on its own - similar to the U.S. That’s because wage inflation is bleeding into the services sector. The reason: European firms are raising pay to recruit new hires given a surge in workers jumping to the public sector. That labor marker tightness looks set to persist. Data last week confirmed euro area unemployment is near a record low. The ECB faces a stark trade-off between pushing up unemployment or living with persistent inflation. ECB officials seem determined to do “whatever it takes” to get inflation down to target, in our view, as that is their only objective. We expect the ECB to raise rates through mid-year and not cut them until the second half of 2024.

Income opportunities

We think this backdrop of higher rates and persistent inflation boosts the appeal of high-quality European credit and short-term government bonds. Yields have jumped from their ultra-low levels reached during a decade of negative interest rates. Strong corporate balance sheets limit the risk of credit defaults when recession hits, in our view. We’re overweight both on a tactical horizon of six to 12 months. We also turn to credit for income from a strategic horizon of five years and beyond.

Equity view

We don’t think European stocks are pricing in the economic pain we see ahead even as valuations look inexpensive relative to the past and regional peers. Stocks could also lose support if foreign investors’ attention shifts, as it historically has. We’re tactically underweight developed market ((DM)) stocks, including Europe. Within Europe, we favor the financial sector as rates rise. We also like the energy sector given the energy shortage, stronger balance sheets and better return on equity than in the past. We favor healthcare on its relatively steady cash flows in economic downturns and strong growth potential from long-term trends like aging populations. Plus, we like the consumer discretionary sector as European brands benefit from ramped-up demand for luxury goods from China’s restart. Our preferences underpin why we’re neutral on Swiss stocks compared with our overall underweight in Europe. The financial, healthcare and consumer staple sectors dominate the index. We are strategically overweight DM stocks and expect earnings to recover once recessions end. We also see returns surpassing bond returns as yields rise due to investors demanding more compensation for risk amid high inflation and heavy debt loads.

Bottom line

European risk assets have outperformed so far this year. But we think that trend will end as recent data pushes the ECB to raise rates and keep them higher for longer. We prefer income from credit and short-term government bonds. We’re underweight European stocks but like the financial, energy, healthcare and consumer discretionary sectors.

This post originally appeared on the iShares Market Insights.

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