Vive La Eurozone

Quick read

• In our view, a sharp economic downturn in the Eurozone now appears unlikely. The combination of preemptive energy storage, fiscal policy action, and resilient domestic demand have mitigated the risk of industrial shutdowns and a sharp drop in household disposable income.
• We anticipate a more resilient European economy in 2023. We believe European equities will outperform US equities, but continue to believe European sovereign government bonds will underperform.

“Textbook economics will not avert this winter’s energy catastrophe”, “Europeans are Bundling Up For Energy-Saving Winter” and “Europe is Going to Party Like It’s 1979,” are just a few of the attention-grabbing headlines written at the end of summer in 2022.¹ Heading into the autumn, the news was nearly uniformly doom and gloom on the economic prospects for Europe. Now, a couple of weeks before the actual start of the winter, views on Europe have shifted markedly. According to both economists and asset markets, it increasingly looks like springtime will arrive early in Europe. This recent unwind of negativity is aligned with the GTAA team’s economic insights and our portfolios remain positioned for markets to price further improvements in the Eurozone outlook in the coming months.

The Russian invasion of Ukraine in early 2022 triggered large downward revisions to 2022 economic forecasts across most European indicators. However, despite the war continuing for longer than expected, the European expansion has thus far proven more resilient than expected. The plot below shows the improvements to end-of-2022 economics forecasts across a few key variables over the course of the year. The onset of the war in early 2022 triggered large downgrades to GDP and consumption growth and a slight uptick in wage expectations. But as policymakers and firms enacted policies to mitigate the economic risks, the downgrades began to reverse in the late summer. The continued upgrades to both consumption and wage growth estimates in recent months are consistent with a more resilient outlook for Europe.

Consensus estimates for the Eurozone have recovered in recent months

Eurozone equities see light at the end of the tunnel

The economic risks of gas ratioining and mandated industrial shutdowns in the winter were highly salient this past summer. Credit and equity markets reacted by pricing in some risks of defaults and hits to earnings. Thankfully those worst-case fears have thus far proven misplaced - global supplies of piped and liquified natural gas were redirected to Europe to refill storage depled by Russian sanctions and shutoffs; policymakers enacted large and targeted fiscal relief packages to mitigate unbounded utility price rises; and households and firms have proactively cut extranous energy demand. A little bit of good luck with a warm autumn weather and the pricing out of tail downside scenarios was particularly strong in equity markets. Recent surveys of companies and households show curbs to energy demand have mitigated rationing risks without denting economic output.²

As shown in the plot below, the recent rebound in global equities has disproportionately benefitted European markets. Germany and France have strongly outperformed the US, and even the UK has managed to ek out relative outperformance in spite of the budget turmoil and challenges in its government bonds markets.

European equities have outperformed US equities since the end of summer

Will the European Central Bank agree?

One of the bigger surprises to markets this year has been the rapid normalization of monetary policy in the Eurozone. Despite the aforementioned growth concerns, the European Central Bank (ECB) has remained resolute to adhering to its singular inflation mandate and hiked interest rates into positive territory to slow inflation. However, November’s preliminary readings of headline inflation of 10% and core inflation of 5% continue to remain uncomfortably high versus the ECB’s 2% target. With some of the worst downside risks to growth having been priced out, we believe that markets have underappreciated that policy rates across Europe are likely to remain higher for longer. The ECB needs to tighten further, and it is likely to deliver more than is currently priced by markets.