In a widely expected move, the European Central Bank (ECB) raised its benchmark interest rate by 75 basis points (bps) at its policy meeting on September 8, citing inflation that remains “far too high” following a 9.1% increase in August. According to a post-meeting statement, policymakers expect to raise rates further to “dampen demand and guard against the risk of a persistent upward shift in inflation expectations.” Markets had been alerted to the possibility of a 75-bps hike based on commentary following the U.S. Federal Reserve’s Jackson Hole conference at the end of August that noted similar challenges in the United States.
The ECB decision comes against a backdrop of a worsening energy crisis, as Russia had recently announced that it was stopping the delivery of natural gas to the region through the Nord Stream 1 pipeline, an event that could worsen the inflation picture.
In its statement, the ECB emphasized that it remains “data dependent,” and that it will address policy decisions on a meeting-by-meeting basis, which is something they’ve said before. One of the challenges facing the ECB is determining a neutral rate, something it has not been able to clearly define in the past. Now, markets expect the ECB to raise its benchmark refi rate to about 2% from the 0.75% level reached after the September meeting. In a post-meeting press conference, ECB President Christine Lagarde said the bank could be hiking rates at the next two to five meetings.
The ECB also issued updated economic projections, with eurozone growth seen at 3.1% in 2022, 0.9% in 2023, and 1.9% in 2024. But the energy crisis presents a formidable obstacle to growth, and in our view, the forecasts appear overly optimistic; it is more likely that the eurozone will see zero percent growth in 2023. The ECB sees the harmonized index of consumer prices (excluding food and energy prices) averaging 3.9% in 2022, 3.4% in 2023, and 2.3% in 2024—finally nearing its 2% inflation target.
Looking Ahead
Unfortunately for the central bank, a lot of the elements that will determine the future trajectories of growth and rates are out of the ECB’s hands. At this point, developments in energy and energy policy are going to be an outcome of geopolitics, and the actions of individual governments in the region. Governments are planning a new round of stimulus spending, which should cushion some of the effect of soaring energy prices on consumers and businesses, but they’re also at the mercy of Mother Nature: a colder-than-expected winter may require more conservation or worse, rationing; alternatively, a warmer-than-forecast winter may alleviate the worst financial effects of energy shortages. This is obviously a tricky time to run a central bank, but Lagarde’s remarks at the September ECB press conference indicated some resolve to continue tightening to try to dampen inflation expectations. But at some point, if the associated hit to economic growth becomes untenable, the ECB may have to abandon its rate-hike regime. We may see a very strong “stop-and-go” policy cycle at the central bank in coming months.
What are the investment implications of the current direction of ECB policy? We expect some flattening in the German yield curve as the ECB hikes and reduced growth expectations keep the longer-date yields down. Another development to watch is the strength of the euro; the common currency has already depreciated quite a lot, but if the market gets a sense that the ECB is going to have to halt its rate hikes, more depreciation may be in store.
All this ties into the debate whether the recent weakness in eurozone asset prices presents a compelling opportunity over a longer horizon like six months to one year. The region still faces deteriorating fundamentals and heightened uncertainty regarding geopolitics and energy supplies, with the potential for larger “left-tail” outcomes not yet accounted for in the price. However, select valuations are starting to get interesting, particularly when you consider that investor positioning that has remained light in the region. While a wholesale reallocation by investors to the eurozone is not likely in the cards yet, market moves of the current magnitude can always present idiosyncratic opportunities that counter overall market beta. For example, large, geographically diversified, non-European domiciled businesses that access the European capital markets could present an opportunity when outflows have led to indiscriminate risk shedding. More broadly, signs that the ECB’s more restrictive stance has not dampened growth too quickly—and that energy-price pressures have moderated—will be crucial in determining whether to increase overall investment weightings in the eurozone.
