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The ocean

Wealth Insights | Europe

Europe in the Eye of the Storm

Europe is at the epicenter of the geopolitical events impacting world markets. The war in Ukraine has catapulted inflation higher in Europe and the West, destabilizing the supply of food commodities and natural gas. Despite the exogenous nature of the shock, the events have caused central banks to change longstanding interest rate policies. The European Central Bank (ECB) has just mimicked the Fed’s initial rate move, raising policy rates unexpectedly by 50 basis points.

CIO believes the ECB will likely deliver a total of 150bp in rate hikes in this tightening cycle, bringing the deposit facility rate to 1% by December 2022. Another 50bp hike in September followed by two 25bp hikes in October and December are likely, but changes in the macroeconomic outlook could alter the speed and magnitude of the ECB’s moves. CIO also sees little chance of the ECB going into reverse unless inflation projections signal a clear undershooting of the central bank’s 2% target. Therefore, CIO believes the ECB tightening cycle will likely be sharp but short.

  • For the moment, Europe is not in a recession. Domestic demand is being supported by a tight labor market as well as above-average employment expectations. In fact, some businesses are reporting sustained recruitment difficulties. However, we expect that present conditions are likely to come under significant pressure as we enter fall and winter. Investor sentiment in Europe has already taken a turn for the worse. The Sentix survey of investor expectations gauging the position in the business cycle - and just as importantly household sentiment - signal recessionary conditions are likely in the six months ahead.

  • CIO’s base care for Europe in the coming quarters assumes that natural gas will continue to flow from Russia to Europe, albeit at much lower volumes than in the winter of 2021-22, due to the war and resultant geopolitical tensions. The clear risk in coming months is that volumes decline to such low amounts that aggressive rationing strategies need to be implemented. Citi analysts doubt this is something Russia will aim for in the short term, as the high price of gas is generating a meaningful source of much need revenues.

  • As long as Europe’s economic stresses remain regional and financial shocks are not transmitted elsewhere, a 2022 second half contraction in real GDP fits our base-case RESILIENT scenario for the world economy.

Chart: Euro area inflation (headline, core and ECB target)

Portfolio Considerations

CIO believes European markets have priced in an economic slowdown, but not a recession. If there was a further significant reduction to gas flow to Europe, CIO could expect another 10% contraction in European EPS over the next 12 months and further downside to European markets, especially across energy sensitive sectors. Given the growing complexities and uncertainties in the euro area, CIO remains underweight European ex-UK equities, while taking advantage of some defensive properties in UK equities. Similar to other major equity markets, earnings expectations remain elevated, supported by energy, metals and mining sectors, which have benefited from a global shortage of commodities this year. Even after excluding commodities, estimates for 6.2% earnings growth among the remaining European sectors seem too lofty, considering macro headwinds.