European Central Bank action

The ECB’s era of negative rates has finally come to an end, and with quite a bang - but it’s not against a backdrop of strong economic growth and certainly not accompanied by celebratory smiles. Quite the contrary.

The ECB is hiking into a drastically slowing economy, facing a severe stagflationary shock that is quite beyond its control, while also facing an Italian political crisis which presents a difficult sovereign risk dilemma. There is no other developed market central bank in a worse position than the ECB.

Yet the weakness of the Euro area economy suggests they will not tighten anywhere close to the Fed.

European inflation

The Ukraine crisis has inflicted a blow to the global economy. Russia and Ukraine are key commodity exporters so not only has broad sentiment plunged in response to this conflict, but energy and food prices have soared. In the face of such significant price pressures, global economic growth is starting to slow with PMI activity indicators moving sharply lower. The downside pressures are greatest for Europe and parts of emerging markets, but the U.S. economy also faces considerable challenges.

Europe’s dependence on Russian gas means that it is facing very significant energy price increases and peak inflation is still several months away.

European valuations

At the start of 2022, U.S. equities had rarely been more expensive. Now after falling into bear market territory, it is certainly more attractive – but, in historical terms, only slightly. Indeed, the U.S. has still been cheaper almost 80% of the time. By contrast, parts of Europe, where equity losses have also been significant, are flashing green. Relative to the U.S, Europe has rarely been less expensive. In particular, in pockets of emerging markets, valuations would suggest that EM offers great buying opportunities. For example, Brazil has never been cheaper.

From a fundamental perspective, large caps will be challenged by their global exposure. Although the U.S. economy is slowing rapidly, the outlook is worse for Europe and large parts of EM. By contrast, mid-caps tend to be more domestically focused, whilst they also have less sector concentration.

European natural gas

The energy crisis in Europe is escalating. With natural gas flows from Russia to Germany through the Nord Stream 1 pipeline having fallen to just 20% of capacity, the threat of a gas supply shortage has become meaningfully more acute in recent weeks.

The increase in European gas prices has been particularly sharp. Since January 2021, natural gas prices have risen almost 760%, significantly more than the 240% increase seen in the U.S. The surge is deeply impacting Europe’s economy, pushing inflation to record highs, driving up household bills, and straining Europe’s industrial sector. Price increases are not Europe’s only problem. Germany, which imports 55% of its gas from Russia (compared to the 40% EU average), also faces a potential gas supply shortage.

- The European Commission estimates that, if supplies are sustained at 40% of capacity, Germany could narrowly scrape through the winter without shortages.
- At 20% of capacity, Germany would face shortages, therefore needing some notable rationing, with clear negative growth implications.
- If Russian gas flows stop entirely, the Bundesbank estimates that the necessary rationing of gas would lead German GDP to slump 5%.

As with any geopolitical risk, the situation elevates uncertainty for investors. However, with such a grave winter threat hanging over the region, the European investment proposition looks considerably less enticing than that of the U.S.