Europe: Sticky Inflation Favors Income
Market pricing of peak and end-2024 ECB policy rate, 2022-2023
Source: BlackRock Investment Institute, with data from Refinitiv, March 2023. Notes: The orange line shows peak or terminal ECB policy rate expectations based on futures prices. The pink line shows expectations for the end of 2024, the yellow line shows the actual path of the ECB deposit rate.
Euro area stocks have outperformed U.S. peers by about 14% in local currency terms since the end of September, MSCI index data shows. That’s partly because the economy has withstood the energy crunch even as the war in Ukraine drags on. Plus, export-centered sectors also look set to benefit from China’s restart. Yet good news on growth now means the ECB has more work to do to cool inflation later, as we said for the U.S. We think that’s bad news for Europe’s risk assets. We see policy rates already on track to tip the economy into recession this year after growth stagnated at the end of 2022. Data last week showing core inflation rising and services activity improving may push the ECB to hike more. Market pricing now expects rates to peak around 3.9% (orange line in chart) versus about 3.2% in February, with fewer rate cuts seen in 2024 (pink line).
Europe’s cooling goods inflation and lower gas prices have driven a drop in overall inflation. We think elevated services inflation will prevent inflation from falling to the ECB’s 2% target on its own – similar to the U.S. That’s because wage inflation is bleeding into the services sector. The reason: European firms are raising pay to recruit new hires given a surge in workers jumping to the public sector. That labor marker tightness looks set to persist. Data last week confirmed euro area unemployment is near a record low. The ECB faces a stark trade-off between pushing up unemployment or living with persistent inflation. ECB officials seem determined to do “whatever it takes” to get inflation down to target, in our view, as that is their only objective. We expect the ECB to raise rates through midyear and not cut them until the second half of 2024.