Takeaways from Europe's big week

Last week was a critical one for Europe as investors waited to see whether gas supplies from Russia via the Nord Stream 1 pipeline would resume after the end of the scheduled maintenance period on 21 July. Meanwhile, the European Central Bank prepared to announce its first rate hike since 2011, and to introduce a new tool designed to control bond spreads within the Eurozone as rates are increased.

The ECB meeting came at a juncture made all the more delicate by the resignation of Italian Prime Minister Mario Draghi. His departure—just a few hours before the ECB announced its policy decision—added to political uncertainty in Europe’s third-largest economy, prompted a widening in the spread between 10-year Italian BTPs and German Bunds, and triggered a snap election that will be held in the fall.

The ECB surprised markets by increasing the deposit rate by a larger-than-expected 50 basis points, lifting it back to zero and bringing to an end both the era of negative interest rates and the era of forward guidance.

Policymakers also announced a new Transmission Protection Instrument (TPI), the proposed size of which will be unlimited and determined by the scale of the risk posed. The use of the TPI is open to all countries, and conditionality is limited. To be eligible, countries will have to meet four criteria, which will be decided on by the ECB alone:

1. be in compliance with the EU fiscal framework;
2. have an absence of severe macroeconomic imbalances;
3. have a fiscally sustainable budget; and
4. have sound and sustainable macroeconomic policies.

In an initial reaction, bond yields and the euro rose on the larger-than-expected rate hike. But this was reversed on Friday as investors focused on the continuing risks of recession: S&P Global's flash composite Eurozone PMI for July fell to 49.4 from 52 in June, pointing to a contraction in business activity. On the week, yields on 10-year German Bunds fell 8 basis points, the spread between the yields on Italian and German 10-year bonds widened by 13 basis points, and the EuroStoxx 50 advanced 3.4%.

We see the following implications from the ECB’s action:

• The ECB must tread a narrow path between fighting inflation and avoiding recession. With inflation at uncomfortably high levels and likely to rise further in the coming months, we expect the ECB to keep a quick pace on its path to neutral rates. Thus, notwithstanding the slowing growth backdrop, we expect a further 50-basis-point hike at the September meeting, followed by 25-basis-point increases in October and December. If the Eurozone avoids a recession through the winter, then we see scope for further hikes in 2023. However, if the considerably large and growing downside risks materialize, then we expect the ECB to pause in December.
• The absence of TPI volume limits and achievable fiscal requirements will likely be supportive of bond spreads, but the discretion around when TPI will be activated can still allow for significant valuation losses on peripheral bonds. We therefore retain a cautious stance on peripheral Eurozone assets considering the risk of a looming European recession.
• The abandonment of forward guidance will likely spur rate volatility ahead of the next ECB meetings, as investors are left to speculate about the size of future hikes. Apart from inflation, the Russia-Ukraine war and gas supplies to Europe will likely have a significant impact on the outcome, and both are hard to predict. For example, while the flow of Russian gas through the Nord Stream 1 pipeline resumed last Thursday, it did so at 40% of capacity, the same lower level of supply prevailing prior to the maintenance closure. That reduced supply is unlikely to be sufficient for Germany and other nations to build up enough gas storage for the winter, posing considerable headwinds for the European economy.

So, against this uncertain economic and geopolitical backdrop, we continue to advise investors to avoid positioning for any single scenario. We recently cut our 2023 Eurozone earnings estimate to 15% below consensus. While we believe current Eurozone equity valuations already reflect the earnings weakness that we anticipate—which is why we expect Eurozone equities to be broadly flat by year-end—in the event of an abrupt halt to Russian gas supplies, earnings could potentially slump around 30%. Hence, we believe investors should ensure their portfolios are sufficiently robust to weather any outcome.

Within the region, we favor higher-quality, attractively valued stocks that are better able to withstand rising bond yields, slowing growth, and market volatility. We hold a least preferred view on the euro, given the risks from the war, gas supply, and recession.

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