Is the Old Lady going too slowly?
Russell Silberston discusses how the Bank of England is an international outlier in relying on models rather than data to anticipate inflation
After a challenging 2022, the eurozone economy entered 2023 on a stronger footing, benefiting from the fading 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 have strengthened significantly in recent months; from 30th September 2022 to 30th June 2023, European equities (represented by the Euro Stoxx 50) were up over 30%, government bond yields (represented by German 10-year bonds) have risen over 40 basis points and the euro has risen over 10% vs the US dollar. However, there is increasing evidence that the factors that have underpinned the improvement in sentiment are beginning to unwind.
The more supportive backdrop – in addition to still elevated inflation – has led the European Central Bank to rapidly tighten policy, adding to the 2.5% of rate hikes implemented in 2022 with a further 1.75% in 2023 and beginning the process of running down its balance sheet in March. As a result of these actions, there is evidence that policy is significantly tight in the eurozone. In particular, the German yield curve, denoted by the difference between the yields on 3 month and 10-year government bonds, is inverted by 1%, which is the most since 1992 (Fig. 1). All things being equal, an inverted yield curve is likely to act as a headwind to growth as it suggests the cost of borrowing today is 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 (Fig. 2), reflecting the impact of the higher cost of borrowing as well as tighter lending standards.
Fig. 1: Germany 3-month vs 10-year yield curve
Source: Ninety One, July 2023.
Fig. 2: Eurozone loan growth 3-month annualised
With policy having become increasingly tight this year, there is now increasing evidence that the rebound in data flow and sentiment over the last nine months is behind us. Indeed, 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, growth data has turned over rapidly in a broad-based manner. 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 (Fig. 3). Meanwhile, measures of the service sector such as the Purchasing Manager Index (PMI) and the IFO survey, having bounced substantially at the beginning of this year, are now suggesting that growth in this sector has stalled to close to zero. The renewed weakness in services is coming at a point where manufacturing growth has continued to weaken substantially, driven by weaker external demand from (a) a softer China; (b) a significantly stronger euro; (c) an inventory overhang which is weighing on firms’ orders growth; and (d) weak domestic demand (Fig. 4).
Fig. 3: Eurozone data surprises
Source: Ninety One, July 2023.
Fig. 4: Eurozone Purchasing Manager Indices
Typically, weak growth would lead policy makers to act by loosening policy. However, previously elevated inflation, an abandonment of setting policy based on forecasts, and a steadfast commitment to defending their inflation target has meant the ECB has instead chosen to pursue further policy tightening, communicating that it expects policy to remain at tight levels well into the future. The lags involved from policy actions to the real economy means we are yet to see the full impact of this recent tightening, which in our view, has increased the risk that policy has already been overtightened. This is likely to become apparent in the coming months.
Despite inflation remaining uncomfortably high, there is emerging evidence of it heading downwards. The last three months of data shows headline inflation at the 2% target having benefited from weaker commodity prices. Inflation – excluding volatile items such as food and energy – is at 4.3% having fallen from close to 7% in the middle of 2022 (Fig. 5), as a function of softer goods prices as well as slowing service price growth which had remained stubbornly high. It is this part of the inflation basket that the central bank is paying closest attention to. Our view is that the improving inflationary backdrop alongside significantly weaker growth momentum is likely to put a cap on the degree to which the ECB tightens policy further, despite market pricing on the contrary.
Fig. 5: 3-month annualised inflation
Source: Ninety One, July 2023.
We believe there are attractive opportunities based on this view that European assets aren’t pricing this dynamic, and currently favour German government bonds with 10-year and 30-year maturities, which remain 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.
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