Key takeaways
· The euro area’s economic activity is weak but normalising as inflation falls and real incomes improve, leaving room for looser monetary policy this year. We expect an ECB cutting cycle to start this spring
· We see the euro area’s GDP growth rising more than consensus in 2024. While German weakness is acting as a drag on growth, its fiscal austerity is not echoed elsewhere
· Geopolitical tensions threaten to impact Europe more than other regions, yet the EU has a history of adapting through crises
· We see few catalysts for active investment positioning and for now believe that the outlook calls for a neutral tactical exposure on euro area financial assets.
Can the euro area’s economy overcome 2024’s challenges? Uninspiring growth, domestic politics and geopolitical threats combine into a testing year for the region’s 20 economies. Crises in the past have often seen the bloc innovate. As markets anticipate normalising monetary policies and growth, we believe the outlook calls for a neutral tactical stance on European stocks, bonds and the euro.
European indicators suggest that manufacturing and services activity is weak, but has stabilised over the past three months, and household savings as a share of income are also stable. Our above-consensus forecast is that gross domestic product (GDP) growth will reach 1.1% in 2024 as real incomes are improving, savings are high, monetary policy is poised to ease, and unemployment is at an historic low (see chart 1).
However, competition has intensified as China becomes the world’s number one vehicle exporter, undermining Europe’s once-dominant role. More broadly, slow growth, coupled with uncertainties over the German economy, the region’s largest, and global tensions that have deeper implications for Europe than the rest of the world, mean that we maintain a neutral tactical positioning on eurozone-exposed assets.
Priced-in rate cuts
The ECB has over-tightened monetary policy, we believe, responding to a supply shock as if it were a US-style demand boom. With the economic impact of the energy shock now behind us, eurozone inflation has plummeted to levels not seen since Russia’s invasion of Ukraine almost two years ago (see chart 2) – and would likely have fallen dramatically – even in the absence of 450 basis points (bps) of interest rate hikes.
In December 2023, eurozone headline inflation stood at 2.9%, down from over 10% a year earlier, and suggesting that the measure is already closing on the ECB’s 2% average target. It is likely that most of the impact of higher borrowing costs is now absorbed by the economy, as the ECB expects inflation to average 2.7% over 2024, half of 2023’s level.
That has prompted investors to expect a first interest rate cut from the ECB this spring. Market consensus implies ECB cuts of roughly 150 bps in 2024 from today’s 4%. Such an aggressive pace of easing would be more consistent with a recession, and we think the ECB is likely to take a more measured approach, cutting rates by 100 bps this year. Last week’s comments by ECB President Christine Lagarde suggesting that a start to the rate cut cycle is not imminent, point in this direction.
However, while we expect the ECB to move more slowly than market consensus this year, we also see the central bank cutting rates further over the cycle. In our view, the ECB should reduce rates below 2% in 2025 (see chart 3).
German drag
Europe’s largest economy is acting as a drag on the euro area’s growth. After Germany’s constitutional court ruled in November that a spending package would violate the country’s ‘brake’ on government debt, a compromise leaves the nation with an austere annual budget. Politically, the crisis has also weakened the coalition government at a time of widespread discontent with higher prices and subsidy cuts. However, it is worth noting that Germany’s shift to tight fiscal policy is not matched by other euro area economies. By contrast, fiscal impulse is contributing positively to growth elsewhere, as the periphery is benefitting from substantial recovery fund inflows.
Germany’s political difficulties will be tested when some of its states go to the polls in local votes in September. Polls suggest a shift to the right, which may also be echoed in June’s European Parliamentary elections and will form a backdrop as the bloc navigates a path to approve financial support for Ukraine.
Geopolitical threats
At the geopolitical level, tensions from Ukraine to the Middle East are also impacting the eurozone. The region’s supply chains are more affected than other parts of the world by disruptions to Red Sea traffic. In the wake of attacks on shipping there, global container costs have leapt from less than USD 1,500 per 40-foot container between Shanghai and Rotterdam in mid-December, to more than USD 4,400 a month later, reflecting the longer journey times between Asia and Europe via southern Africa. For the global economy, this should be put in context; the largest price rises are limited to routes between Asia and Europe, and prices peaked more than three times higher than these levels in 2021 following China’s Covid shutdown.
For Europe, a second Trump administration in the US from 2025 may create new trade tariffs as well as questioning US support for Ukraine, and potentially undermining NATO’s strategic coherence.
Vorsprung durch Politik?
Historically, the European Union has been criticised for only evolving through periodic crises. Europe’s outlook has been challenging for many years, but even in the face of the sovereign debt crisis, the global pandemic and energy price shock that followed the Ukraine war, the worst scenarios have been avoided and challenges often resulted in common solutions, including new funding mechanisms.
From an investment standpoint, we see few catalysts for higher levels of active investment exposure to European equities within portfolios. Europe’s equity markets are recording new cycle highs, and in valuation terms German and French indexes continue to trade at a discount versus the US. However, an investment case depends not just on valuations but also the outlook for growth, while the sector weighting and corporate culture continue to favour US equities in our view. We see US stocks as core portfolio holdings, as we do European equities in euro-denominated portfolios, and have no tactical bias currently to the region.
Given our view on policy rates, the case for an overweight bond exposure is clearer, but also somewhat postponed into the future. Policy rates will trend lower, but as mentioned, we expect that trend to start more slowly and then endure for longer than consensus expectations currently assume. With that in mind we have taken some profits on investment grade bonds, lowering them to strategic levels after a sharp decline in yields, tighter spreads, and amid high new issuance.
As for the common currency, in 2023, the euro largely traded in a narrow range between 1.06 to 1.12 US dollars per euro. We expect to see the region’s slower growth to weaken the common currency against the US dollar over the first quarter of the year. As such, we see the euro falling from its current level around 1.09 euros per dollar towards 1.04 in the coming months. In contrast, we anticipate some tactical appreciation by the euro against the Swiss franc, since the Swiss National Bank has halted its currency purchases and we believe that bullishness on the safe haven franc is overdone.