The effects of the inflation wave crashing over the Eurozone and especially in the US are not temporary. As high energy prices persist and second-round effects still have to find their way into the economy, analysts question the ECB’s reluctance to act and raise eurozone interest rates. “Can the ECB claim that all is well and good and stick to its latest statements and position? The markets do not seem to believe that.”
In the run-up to Thursday’s ECB meeting, inflation expectations in the eurozone, measured by the 5y/5y swaps, rose to their highest level since 2014.
Core inflation also remains well above the ECB’s 2 percent target. The ECB on Thursday appeared to change its tone on inflation. The ECB’s official policy announcement barely addressed recent inflation data, but at the press conference President Christine Lagarde said policymakers now are “unanimously concerned”. (See our earlier story.)
Inflation has come to a point where markets reckon with almost three interest rate hikes by the ECB this year, after eurozone inflation rose to 5.1 per cent. Belgium is even the ‘inflation champion’ with an annual inflation rate of 8.5 per cent. The Netherlands, with a year-to-year rise of 7.6 percent in January, also ranks among the inflation leaders in the eurozone.
However, some expect, like the ECB, that inflation will decline later this year. Nicola Mai, portfolio manager at the world’s largest bond investor Pimco, writing in their regional outlook for 2022, sees a drop from 5 percent now to 1.5 percent by the end of this year.
Moderate wage growth
According to Mai, economic growth in the eurozone will still be moderate in the first few months of the year due to disruptions in supply chains, higher energy prices and coronagraph-related restrictions. As the economy normalises afterwards, it is expected to post “fairly robust growth” in the spring, helped by excess savings and strong pent-up demand.
Mai sees inflation in the eurozone rising to 5 per cent year-on-year at the start of this year. After that, however, it will fall to 1.5 per cent by 2022.
“This decline is partly due to significant negative base effects in terms of energy prices, as well as fading effects of supply-side bottlenecks and the opening of economies on core prices,” she said.
Inflation in the euro area is lower than in the US and the UK due to moderate wage growth and the fact that inflation has been too low in the past. A weaker response by eurozone governments is also a factor.
Sticky
However, inflation is much more “sticky” than generally assumed or predicted by analysts and central bankers, said Frank Vranken (pictured), Chief Investment Officer of Edmond de Rothschild Luxembourg. “The central bankers in the US have no choice but to raise interest rates in order not to lose face and to maintain their credibility. Inflation is much more persistent than what analysts and central bankers had predicted,” he said.
Moreover, second-round effects are visible in terms of wage demands and wage increases, he said. The costs of goods has also risen dramatically. Prices for finished goods leaving the German factory gates, for example, have risen by as much as 20 per cent in a short space of time. Food prices are also rising sharply, and negotiations between supermarkets and suppliers, such as Nestlé, are becoming increasingly bitter. “The consumer will feel that. So we haven’t seen the end of it yet,” said Vranken.
Cooling down
Vranken questions the ECB’s forecasts saying that inflation will cool down to 2 per cent sometime next year. That assumption is now under pressure.
“To curb inflation, we need a series of monthly interest rate hikes of no more than 0.2 percent. That has not happened for some time, and is not in the pipeline in the short term. So can the ECB claim that all is well and good and stick to its latest statements and position? The markets do not seem to believe that,” he said.
Already, rate hikes are being priced in in 10bp increments per rate hike. The December 3-month 2022 Euribor stands at an implied rate of -17.5bp, which is up some 38bp from current levels.
Asset classes
Meanwhile, a lot of damage has been done to indices such as the S&P 500 and the Nasdaq. At first glance, the damage is not too bad, but the percentage of stocks trading above their 200-day average on the Nasdaq fell below 25 percent on 19 January for the first time since April 2020. Today, we are trading around 14.2 per cent.
Value, on the other hand, is shining like never before.
For example, European value stocks experienced the best relative month… ever.
The (technical) damage is also considerable for small caps. According to JP Morgan, the valuations of small caps are at their lowest level in twenty years. The re-rating after Covid has been completely wiped out.
Frank Vranken acknowledges that especially long-duration growth stocks, whose future profits are artificially inflated by extremely low discount rates, are having a hard time and are losing out to more defensive stocks and value. “At Edmond de Rothschild, we have significantly reshaped our portfolios and added more sustainable dividend stocks. They should be able to withstand the inflationary wave, alongside inflation-linked bonds,” he said.
Finally, Philippe Gijsels, chief strategist of BNP Paribas Fortis, sticks to a barbell strategy between growth and value, and also emphasises the benefits of real assets, such as precious metals and real estate.
This article was originally published in the Dutch language on InvestmentOfficer.be, the sister website of InvestmentOfficer.lu in Belgium.