Downside risks partly offset by low valuations and extreme investor caution
A recession induced by an external shock. The EU will start 2023 in a much different situation than a year ago with a war on its doorstep, an aggressive central bank, and new leaders in Germany and Italy.
The upcoming winter will be challenging, despite most national governments providing support to households and enterprises to soften the blow of soaring energy prices. Annual EU inflation now exceeds 10%. The uncertainty of higher natural gas prices and the possibility of energy shortages during the winter have dragged consumer and business confidence to multi-decade lows. The region eked out 0.2% q/q growth in Q3 2022, but leading indicators point to an economic slowdown.
Double-digit inflation has pushed the European Central Bank (ECB) into its sharpest and most aggressive hiking cycle in its 24-year history, lifting interest rates by a total of 200 basis points (bps) from negative territory, where they had languished for eight years, to 1.5% in just over three months. ECB President Christine Lagarde has warned more hikes are in the offing and the market currently projects interest rates to peak at 3% by July 2023. The ECB has understood too late, in our view, that even if inflation is driven by supply-side factors, if it remains too elevated for too long, it could drive second-round effects such as higher wage demands.
Natural gas prices are now “only” 20 percent higher than they were at the beginning of the year
European natural gas forward prices (EUR/MWh)
The line chart shows the one month forward natural gas prices within the euro zone in euros per megawatt-hour during 2020. Prices increased sharply to more than EUR300/MWh from less than EUR100/MWh after the Russian invasion of Ukraine, and started to decline late summer as storage approached full capacity. Prices remain some 20% higher than at the beginning of the year.
Source - Bloomberg
After the winter, once the anxiety of potential energy shortages lifts, we expect economic activity to pick up, as consumption resumes and businesses adapt their supply chains and improve energy efficiency. Moreover, exports should benefit from China’s eventual reopening, which we expect in 2023, and the ultimate stabilization and improvement of the U.S. economy.
The consensus forecast of economists is for a GDP contraction of 0.1% in 2023, but growth of 1.5% in 2024.
Unusually high uncertainty. A number of potential factors could make our expectations too optimistic: a deterioration in geopolitics, with either a worsening of the Russia-Ukraine conflict or heightened China-Taiwan tensions; a bitterly cold winter in Europe leading to energy rationing for industrial uses; the ECB overcompensating for lagging other central banks in tightening policy by keeping rates too high for too long; a slower reform process in Italy under the new government of Prime Minister Giorgia Meloni that puts the sustainability of Italy’s heavy debt load in question; tensions between French President Emmanuel Macron and German Chancellor Olaf Scholz that makes EU policy coordination more challenging and less effective.
Conversely, a number of factors could improve the outlook, including: an earlier reopening of China’s economy, to which the euro area, and Germany in particular, is a big exporter; a de-escalation of the war in Ukraine; natural gas prices falling further from current levels; and inflation peaking early that would enable the ECB to ease monetary policy.
Focus on global leaders. We continue to recommend an Underweight position in European equities given the prevailing uncertainties. However, we acknowledge that the long list of downside risks is partly reflected in sharply discounted valuations and extreme investor caution. Based on a forward 12-month price-to-earnings (P/E) ratio of 12.9x, the MSCI Europe ex UK Index is trading at a discount to its 10-year median of around 14.5x. On a relative basis, the discount to U.S. equities is much steeper than typical, even taking into account sector differences.
European equities have become very cheap compared to U.S. equities
MSCI Europe ex UK Index 12-month forward P/E relative to S&P 500 Index
The line chart shows the 12-month forward price-to-earnings ratio of the MSCI Europe ex UK Index relative to that of the S&P 500 Index from November 16, 2012 through November 11, 2022. . A value above 1.0 indicates that the Europe index is relatively expensive, and a value less than zero indicates the Europe index is relatively cheap. The value was just below 1.0 in April 2014, has trended downward since then, and is now roughly 0.74.
Source - Bloomberg
We continue to prefer defensive sectors over cyclicals, and maintain our bias for quality, globally diversified companies that possess strong pricing power. In particular, we see opportunities in companies which are global leaders within the pharmaceuticals, technology, luxury, and capital goods industries. We are also beginning to see select opportunities in deeply discounted cyclicals where valuations already appear to price in the prospect of a European recession, particularly in sectors such as Industrials and Materials.
European fixed income
Turning tides, focus on higher-quality issuers and income generation
Monetary policy not overly restrictive. European Central Bank (ECB) officials are maintaining that borrowing costs must rise to counter inflation; however, the appetite for jumbo 75 basis point (bps) hikes is waning. The Governing Council judged that “substantial progress in withdrawing monetary policy accommodation” has been made, which hints at a terminal rate that is not overly restrictive. We expect interest rates to peak at 2.50% in 2023, up from 1.5% currently.
Our base-case scenario is based on expectations for inflation to peak in 2022 and start declining in Q1 2023. However, we acknowledge there are risks to that view. On the one hand, with inflation currently at 10.6% y/y and running much above the ECB’s 2022 target, tightening to around 2.75% may be warranted. On the other, a recession and a modest rise in unemployment that is easing wage pressures could result in less restrictive policy with interest rates peaking at around 2.25%. Current market expectations are higher than our three scenarios, with a terminal rate close to 2.90% priced in for mid-2023.
European Central Bank forecasts inflation falling below target in 2024
European Consumer Price Index inflation and European Central Bank (ECB) deposit rate
The line chart shows the European Central Bank’s deposit rate and the EU inflation rate for the period of November 2021 through November 2022, and future projections. Both inflation and the deposit rate have risen throughout the period; the last data point for inflation is 10.7% in September and the last data point for the deposit rate is 1.5% in November. The chart also shows the European Central Bank’s inflation estimates for 2022 (8.1%), 2023 (5.5%), and 2024 (1.90%). Markets expect the deposit rate to reach 2.01% at the end of 2022 and 2.9% in 2023.
Source - Bloomberg, European Central Bank; data as of 11/16/22, 09:35 GMT
A mild recession. RBC Capital Markets forecasts that euro area GDP growth will turn negative in Q4 2022 and Q1 2023 before turning positive for the rest of 2023. Though the euro area is very likely heading into a recession this winter, we expect the recession to be milder than initially feared when the fullness of the energy crisis became clear.
A backstop to prevent material sovereign spread widening. As with other central banks, the ECB will begin the process of reducing the assets on its balance sheet, also known as quantitative tightening (QT). We expect that before selling assets outright, the QT process will likely commence with the ECB merely ceasing reinvestments in Q1. As the central bank shifts to QT and starts to sell sovereign bonds, we would prefer to be positioned in nations with a lower supply glut to minimise the effect of sovereign spreads widening. As such, we have a bias against Portugal, Italy, and Greece as they have been some of the nations most supported by ECB purchases which resulted in tighter spreads. When the ECB transitions to asset sales, we expect spreads to widen and for these most supported sovereign bonds to underperform.
Still, we do not anticipate a disorderly rise in sovereign spreads. We are comfortable with the ECB’s ability to limit an unwarranted rise in the premium investors demand to hold lower-rated euro area sovereign bonds. The ECB’s measures to limit such an outcome can be used at the Governing Council’s discretion with no limitations. Therefore, there is a sufficient backstop to prevent spreads from materially widening, in our view.
Corporate credit opportunities improve after a challenging 2022. Credit yields have risen very sharply from 0.5% to 4% this year alone, which has opened up opportunities in the market. Credit looks compelling to us as investors are now receiving higher yields which we believe should more than compensate for the interest rate risk of their investments. On a risk-reward basis, investment-grade bonds look more attractive relative to high-yield bonds, in our view, due to recession expectations resulting in widening high-yield spreads and the higher cost of borrowing for high-yield issuers.
European credit yields are significantly higher than a year ago
Bloomberg Euro-Aggregate Corporate Index yield by credit rating
The line chart shows the Bloomberg Euro-Aggregate Corporate Index yield by credit rating for the period of November 2021 through November 2022. The chart shows the overall index yield has risen from 0.4% in November 2021 to 4.1% in November 2022. “Aaa”, “Aa”, and “A” rated yields are below the index yield, while “Baa” rated debt yields are above the index yield.
Source - Bloomberg; data as of 11/17/22, 17:35 GMT
Corporate bonds appear well cushioned against further spread widening before returns turn negative, in our opinion. However, we believe it is essential for investors to proceed with caution in credit markets during a period of high inflation and slowing growth. The return potential for credit has improved, in our view, after a challenging 2022 and we see pockets of opportunity. We believe the theme for 2023 is to remain selective and focus on issuer fundamentals. In particular, we prefer senior ranking bonds issued by banks, as well as bonds from commodity and telecoms issuers as these industries possess a combination of the most attractive spreads, credit rating upgrade potential, and resilient cash flows, in our view.