Because the European economy will not be sparkling
Although the outlook for Europe has improved significantly, for the coming months it is preferable to maintain a cautious positioning and monitor the possibilities of a recession and a possible new escalation of the conflict in Ukraine. The analysis of Richard Flax, Chief Investment Officer of Moneyfarm
Despite the initial repricing of monetary policy and the banking crisis in March, the new year started on an optimistic note, with developed market macroeconomic data more resilient than expected and robust earnings seasons in major geographies.
The first quarter was characterized by a divergence between the rather low equity and bond volatility, which was instead high, leading to the return of the traditional decorrelation between the performance of bonds and that of equities, a factor that makes multi-asset portfolios more resilient. Overall, therefore, portfolios withstood the pressure well, thanks to the bond sector which benefited from the drop in rates, and to equities which, after the initial retracement, recovered ground, on the wave of investor optimism.
During the banking crisis in March, which culminated in the bankruptcy of SVB and UBS's bailout of Credit Suisse , rates plummeted and equities suffered, as per the textbook, with the banking sector posting the worst losses. More interesting, however, was the reaction of the markets after the crisis was over.
CENTRAL BANKS AND INFLATION
Although the central bankers have emphasized the strength of the banking system and the will to fight inflation, in fact, rates have remained low and the declarations of Powell and Lagarde were of little use, who, during the two meetings in March , reaffirmed their determination to keep rates high for much longer. The markets bet is twofold: on the one hand, they expect Central Banks to cut rates should the banking crisis worsen; on the other hand, the suffering of commercial banks could represent, counterintuitively, positive news for the fight against inflation, because private institutions would rush to strengthen their balance sheets, issuing less credit and causing a slowdown in economies and, consequently, in the inflationary spiral.
At the end of March, the gap between priced rates and last month's blue dots, which capture the rate hike expectations of participants in Fed decisions, is around 80 basis points, a very high level which makes any bet on duration dangerous . For the time being, it therefore appears that markets are underestimating the Fed's determination to raise rates, and this will push the number of priced hikes higher.
WHAT THE FED WILL DO, MAYBE
However, taking into consideration the fact that the post-banking crisis credit crunch could correspond to an increase of 25-50 basis points, it seems plausible that the American Central Bank could moderate its tone if the economic data (those of the labor market, in particular particular) should surprise on the downside in the next month. However, further significant falls in price expectations do not fit into our base case.
THE FORECAST FOR EUROPE
Comparing the different geographical areas, the MSCI Europe index outperformed the MSCI US by almost 12% from October to the end of March: a difference mainly attributable to the fact that the European winter recorded milder temperatures than expected, a surprise which, on the one hand, prevented the energy crisis from having an impact on the production system of the Old Continent, on the other it significantly improved growth expectations. Added to this are other factors such as the reopening of the Chinese borders, which has given new life to the consumer sector, especially the more cyclical ones, the improvement in consumer sentiment and the high inflation environment, where low valuations have continued to support the performance.
Looking ahead, while the outlook for Europe has improved significantly, a cautious positioning is preferable for the coming months, as inflation is declining year-on-year, but at a slower pace than hoped and remains well above target in most regions. A possible new escalation of the conflict in Ukraine, which would especially penalize European equities, and the possibility of a recession should also be carefully monitored: in both of these cases, we believe that US equities would offer greater protection.
Overall, the most sensible interpretation is that markets expect a scenario in which inflation will continue to slow down, posing less and less of a threat, while the economy will still remain stronger than at the end of 2022, albeit also in slowdown due to the action of the Central Bank. In our view, however, this optimism will soon need to be supported by worsening (even weak) jobs data and a sharp slowdown in inflation, otherwise we could see a partial reversal of the trend.
This is a machine translation from Italian language of a post published on Start Magazine at the URL https://www.startmag.it/economia/europa-economia-prospettive/ on Sun, 30 Apr 2023 05:38:49 +0000.