18 Sept 2023
18 September 2023. At the start of 2023, it was reasonable to think that an economic slowdown after historic monetary tightening would hit the US before the eurozone, in part because the ECB tightened later than the US. There is, however, increasing evidence that it is Europe that is getting there first.
The drivers of the eurozone’s positive economic data surprises earlier this year were the fading of the terms-of-trade shock from natural gas prices, strengthening external demand from Chinese economic reopening, and a consumer that continued to benefit from excess savings built up from the pandemic. As a result, European assets strengthened significantly between the end of September 2022 and end of June 2023: the Euro Stoxx 50 rose by over 30%, German 10-year bonds rose by over 40 basis points and the euro rose by over 10% vs the US dollar.
However, that strength is now likely to ebb. Since the start of the year, the ECB has added a further 1.75% in rate hikes to the 2.5% implemented in 2022. It also started the process of running down its balance sheet in March. There is now evidence that policy is significantly tight in the eurozone, and there are fears the ECB may have overtightened.
One indication, and cause, of tightness, is the significant inversion of the German yield curve, which is a measure of the difference between the interest rates on 3-month and 10-year government bonds. This inversion stands at 1%, the highest it has been since 1992. All things being equal, an inverted yield curve acts as a headwind to growth as it renders the cost of borrowing today higher than the rate of return available from investing in the future. Further, monetary measures have slowed significantly; base money supply is now contracting at an annualised rate of -11%, and loan growth has slowed to 0% from a run rate of 8% in Q3 last year, reflecting the impact of the higher cost of borrowing as well as tighter lending standards.
There is now increasing evidence the rebound in data flow is behind us. Data surprises, which measure the difference between actual economic data releases versus market expectations, are at their most negative since the Global Financial Crisis, suggesting the slowdown has caught many off-guard. Some of the drivers that had benefited the growth backdrop, such as stable natural gas prices and rebounding Chinese growth, are fading, while the tighter monetary backdrop is continuing to weigh on growth in what is a highly financialised economy. As a result, broad-based growth data has rapidly shifted direction.
Meanwhile, measures of the service sector such as the Purchasing Manager Index (PMI) and the IFO survey, hitherto buoyant, are now suggesting that growth in this sector has stalled. The renewed weakness in services is coming at a point where manufacturing growth has continued to weaken, driven by weaker external demand from a softer China; a stronger euro; an inventory overhang which is weighing on the growth of orders; and weak domestic demand. Germany’s manufacturing PMI in August was a wilting sub-40.
Typically, weak growth would lead policy makers to act by loosening policy, making borrowing easier. However, the ECB has instead chosen to pursue further policy tightening for three reasons: continued high levels of inflation, a shift away from basing policy on forecasts, and a commitment to defending its inflation target. The delays between policy changes and their impact on the real economy mean we have not yet seen the full impact of this recent tightening, which in our view, has increased the risk that policy has already been overtightened.
If we see a continued decrease in economic growth momentum, that could serve as a constraint on how much further the European Central Bank (ECB) tightens its policies. This stands in contrast to the expectations in the market, which is anticipating otherwise.
Indeed, one indication that growth is slowing at present is falling inflation. When excluding volatile elements like food and energy, inflation has moderated to 4.3% from its peak of almost 7% in mid-2022. That fall is being driven by a slowing in the growth of service-related costs, which had hitherto remained stubbornly high. Given that this is the part of the inflation basket that the central bank is paying closest attention to, that may give the ECB more policy room than the market is anticipating.
We believe there are attractive opportunities rooted in our view that European assets have not fully priced in this dynamic. Our preference leans towards German government bonds with maturities of 10 years and 30 years. These bonds are currently priced at the cheapest levels for the past 10 years, according to our valuation measures. They should benefit from interest rate expectations falling over the next six months. We also have a negative view on the euro; we believe that any reassessment in growth expectations and lower interest rates is likely to weigh heavily on the currency, given the strength witnessed over the past nine months.