Global Weekly Commentary: ECB may limit hikes as recession nears
Challenges ahead
Europe is facing the risk of an energy shock-driven recession and periphery stress. That’s why we think the ECB will stop hiking earlier than the Fed.
Market backdrop
Relentless U.S. inflation last week signaled a big rate hike by the Fed later this month. Long-term yields fell amid fears rate hikes may trigger a slowdown.
Week ahead
We see the ECB raising rates by 0.25% this week amid high inflation and despite recession fears. We also expect details on its anti-fragmentation tool.
The European Central Bank (ECB) is set to lift rates for the first time in over a decade this week. Both the ECB and Fed are for now pandering to “the politics of inflation,” or pressure to tame inflation. We think the ECB will pause its hiking first. Why? The energy crisis means Europe’s growth is likely to stall soon. Higher rates and political turmoil may also send peripheral borrowing costs spiraling. All this leaves us favoring credit over stocks and neutral on euro area government bonds.
Parity pain
Euro to U.S. dollar
Sources: Refinitiv Datastream and BlackRock Investment Institute, July 2022. Notes: The chart shows the exchange rate of the euro against the dollar since the euro’s creation in 1999. The red line shows the USD to euro exchange rate. The yellow line marks the point of parity, or a 1:1 exchange rate.
In a new regime of increased volatility, the ECB faces an even starker trade-off between crushing growth and living with inflation amid the energy shock. The central bank has yet to acknowledge this, in our view, as its forecast assumes inflation can come down in a growing economy. We think that’s unlikely – and see the euro area growth falling into recession even if rates rise only very little. Why? We’ve argued since right after Russia’s invasion of Ukraine that the energy shock will drag down economic activity. We see the ECB pausing when faced with rapidly slowing growth. Yet markets are still expecting significant hikes in the next year, Refinitiv data on futures pricing show. The dollar’s strength against the euro reflects the more pessimistic growth outlook for Europe, in our view. It’s near parity with the U.S. dollar, its weakest level in 19 years. See the chart.
Why is Europe’s growth slowing? Surging energy prices have heralded a recession in Europe since the invasion, as we said in A new supply shock. The impact on Europe is similar to the oil price shock in the 1970s, in our view. Europe’s reliance on imports means it’s more sensitive to higher energy costs than the U.S. Persistently high energy prices will likely squeeze real incomes, dampen business and consumer confidence as well as elevate financial stress. The drag on growth could be much bigger if Russia restricts supply, spurring rationing and production interruptions. Rationing is of particular concern for Germany, where some worry Russia may use pipeline maintenance as an excuse to cut off the flow of gas.
Peripheral stress
There’s another challenge weighing on the ECB: the risk of the euro zone fragmenting. High debt loads in peripheral nations such as Italy mean slowing growth and higher rates have contributed to widening yield differentials between peripheral bonds and their German counterparts. That prompted the ECB to plan to launch an anti-fragmentation tool: a program to purchase bonds from countries where borrowing costs deviate materially from the rest of the euro area. The ECB is set to give details this week. It hasn’t been easy historically to unite Europe around what is effectively sharing debt. The plan is likely to come with strings attached that could prove politically unpalatable for countries like Italy, where a brewing political crisis is adding to the stress. It’s also not clear when the ECB would use the tool.
Monetary policy can’t save the day, in our view. The ECB faces some brutal trade-offs to get inflation back down to target. We expect the ECB to raise rates out of negative territory to levels not seen since 2013. Yet the fallout of the energy shock and stress in peripheral bonds will force the ECB to pause its rate hikes sooner than the Fed, in our view. That ultimately means the euro area lives with more persistent inflation.
What this means for investments
Tactically, we’re underweight European equities because we see the energy shock stalling growth. We do see opportunities within sectors like healthcare that derive a large portion of revenues from U.S. sales. We favor credit instead amid higher yields and limited default risk. Overall, we dislike U.S. Treasuries and most other government bonds in this inflationary environment. We see the ECB pausing its hiking cycle sooner than the market expects, so we’re neutral on European government bonds. This includes peripheral bonds, even with the vulnerabilities. A key question there is whether markets are over- or underwhelmed by the scope and flexibility of the anti-fragmentation tool. Among global inflation-linked bonds, we prefer Europe. We believe the market underappreciates pressure from the energy crunch.
Market backdrop
Last week’s U.S. CPI data showed inflation reached fresh 40-year highs in June. This likely cements the case for a significant Fed rate hike at its policy meeting later this month, in our view. We also see elevated inflation persisting in Europe, bolstering the ECB’s decision to raise rates this week for the first time in over a decade. Markets showed high intraday volatility with stocks recovering most losses and long-term bond yields ticking lower as the euro leveled with the U.S. dollar.
This week’s focus is on the ECB monetary policy decision. We see the ECB raising interest rates by 0.25% amid persistently high inflation and despite growing recession fears. We also expect more details on the anti-fragmentation tool that’s intended to limit borrowing cost divergences. A series of PMIs will be a key gauge of economic activity around the world.
Week ahead
July 19
UK labor market data
July 20
UK CPI; euro area consumer confidence
July 21
ECB, Bank of Japan rate meets; U.S. Philly Fed business index
July 22
U.S., euro area, UK, Germany PMIs
Source
Past performance is not a reliable indicator of current or future results. Indexes are unmanaged and do not account for fees. It is not possible to invest directly in an index. Sources: BlackRock Investment Institute, with data from Refinitiv Datastream as of July 14, 2022. Notes: The two ends of the bars show the lowest and highest returns at any point this year-to-date, and the dots represent current year-to-date returns. Emerging market (EM), high yield and global corporate investment grade (IG) returns are denominated in U.S. dollars, and the rest in local currencies. Indexes or prices used are: spot Brent crude, ICE U.S. Dollar Index (DXY), spot gold, MSCI Emerging Markets Index, MSCI Europe Index, Refinitiv Datastream 10-year benchmark government bond index (U.S., Germany and Italy), Bank of America Merrill Lynch Global High Yield Index, J.P. Morgan EMBI Index, Bank of America Merrill Lynch Global Broad Corporate Index and MSCI USA Index.
© 2022 BlackRock, Inc. All rights reserved.
General disclosure: This material is intended for information purposes only, and does not constitute investment advice, a recommendation or an offer or solicitation to purchase or sell any securities to any person in any jurisdiction in which an offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The opinions expressed are as of July 18, 2022 and are subject to change without notice. Reliance upon information in this material is at the sole discretion of the reader. Investing involves risks.
In the U.S. and Canada, this material is intended for public distribution. In the European Economic Area (EEA): this is Issued by BlackRock (Netherlands) B.V. is authorised and regulated by the Netherlands Authority for the Financial Markets. Registered office Amstelplein 1, 1096 HA, Amsterdam, Tel: 020 – 549 5200, Tel: 31-20-549-5200. Trade Register No. 17068311 For your protection telephone calls are usually recorded. In the UK and Non-European Economic Area (EEA) countries: this is Issued by BlackRock Advisors (UK) Limited, which is authorised and regulated by the Financial Conduct Authority. Registered office: 12 Throgmorton Avenue, London, EC2N 2DL, Tel: +44 (0)20 7743 3000. Registered in England and Wales No. 00796793. For your protection, calls are usually recorded. Please refer to the Financial Conduct Authority website for a list of authorised activities conducted by BlackRock. In Switzerland, This document is marketing material. Until 31 December 2021, this document shall be exclusively made available to, and directed at, qualified investors as defined in the Swiss Collective Investment Schemes Act of 23 June 2006 (“CISA”), as amended. From 1 January 2022, this document shall be exclusively made available to, and directed at, qualified investors as defined in Article 10 (3) of the CISA of 23 June 2006, as amended, at the exclusion of qualified investors with an opting-out pursuant to Art. 5 (1) of the Swiss Federal Act on Financial Services ("FinSA"). For information on art. 8 / 9 Financial Services Act (FinSA) and on your client segmentation under art. 4 FinSA, please see the following website: www.blackrock.com/finsa For investors in Israel: BlackRock Investment Management (UK) Limited is not licensed under Israel’s Regulation of Investment Advice, Investment Marketing and Portfolio Management Law, 5755-1995 (the “Advice Law”), nor does it carry insurance thereunder. In South Africa, please be advised that BlackRock Investment Management (UK) Limited is an authorized financial services provider with the South African Financial Services Board, FSP No. 43288. In the DIFC this material can be distributed in and from the Dubai International Financial Centre (DIFC) by BlackRock Advisors (UK) Limited — Dubai Branch which is regulated by the Dubai Financial Services Authority (DFSA). This material is only directed at 'Professional Clients’ and no other person should rely upon the information contained within it. Blackrock Advisors (UK) Limited - Dubai Branch is a DIFC Foreign Recognised Company registered with the DIFC Registrar of Companies (DIFC Registered Number 546), with its office at Unit 06/07, Level 1, Al Fattan Currency House, DIFC, PO Box 506661, Dubai, UAE, and is regulated by the DFSA to engage in the regulated activities of ‘Advising on Financial Products’ and ‘Arranging Deals in Investments’ in or from the DIFC, both of which are limited to units in a collective investment fund (DFSA Reference Number F000738) In the Kingdom of Saudi Arabia, issued in the Kingdom of Saudi Arabia (KSA) by BlackRock Saudi Arabia (BSA), authorised and regulated by the Capital Market Authority (CMA), License No. 18-192-30. Registered under the laws of KSA. Registered office: 29th floor, Olaya Towers – Tower B, 3074 Prince Mohammed bin Abdulaziz St., Olaya District, Riyadh 12213 – 8022, KSA, Tel: +966 11 838 3600. The information contained within is intended strictly for Sophisticated Investors as defined in the CMA Implementing Regulations. Neither the CMA or any other authority or regulator located in KSA has approved this information. The information contained within, does not constitute and should not be construed as an offer of, invitation or proposal to make an offer for, recommendation to apply for or an opinion or guidance on a financial product, service and/or strategy. Any distribution, by whatever means, of the information within and related material to persons other than those referred to above is strictly prohibited. In the United Arab Emirates is only intended for - natural Qualified Investor as defined by the Securities and Commodities Authority (SCA) Chairman Decision No. 3/R.M. of 2017 concerning Promoting and Introducing Regulations. Neither the DFSA or any other authority or regulator located in the GCC or MENA region has approved this information. In the State of Kuwait, those who meet the description of a Professional Client as defined under the Kuwait Capital Markets Law and its Executive Bylaws. In the Sultanate of Oman, to sophisticated institutions who have experience in investing in local and international securities, are financially solvent and have knowledge of the risks associated with investing in securities. In Qatar, for distribution with pre-selected institutional investors or high net worth investors. In the Kingdom of Bahrain, to Central Bank of Bahrain (CBB) Category 1 or Category 2 licensed investment firms, CBB licensed banks or those who would meet the description of an Expert Investor or Accredited Investors as defined in the CBB Rulebook. The information contained in this document, does not constitute and should not be construed as an offer of, invitation, inducement or proposal to make an offer for, recommendation to apply for or an opinion or guidance on a financial product, service and/or strategy. In Singapore, this is issued by BlackRock (Singapore) Limited (Co. registration no. 200010143N). This advertisement or publication has not been reviewed by the Monetary Authority of Singapore. In Hong Kong, this material is issued by BlackRock Asset Management North Asia Limited and has not been reviewed by the Securities and Futures Commission of Hong Kong. In South Korea, this material is for distribution to the Qualified Professional Investors (as defined in the Financial Investment Services and Capital Market Act and its sub-regulations). In Taiwan, independently operated by BlackRock Investment Management (Taiwan) Limited. Address: 28F., No. 100, Songren Rd., Xinyi Dist., Taipei City 110, Taiwan. Tel: (02)23261600. In Japan, this is issued by BlackRock Japan. Co., Ltd. (Financial Instruments Business Operator: The Kanto Regional Financial Bureau. License No375, Association Memberships: Japan Investment Advisers Association, the Investment Trusts Association, Japan, Japan Securities Dealers Association, Type II Financial Instruments Firms Association.) For Professional Investors only (Professional Investor is defined in Financial Instruments and Exchange Act). In Australia, issued by BlackRock Investment Management (Australia) Limited ABN 13 006 165 975 AFSL 230 523 (BIMAL). The material provides general information only and does not take into account your individual objectives, financial situation, needs or circumstances. In China, this material may not be distributed to individuals resident in the People’s Republic of China (“PRC”, for such purposes, excluding Hong Kong, Macau and Taiwan) or entities registered in the PRC unless such parties have received all the required PRC government approvals to participate in any investment or receive any investment advisory or investment management services. For Other APAC Countries, this material is issued for Institutional Investors only (or professional/sophisticated /qualified investors, as such term may apply in local jurisdictions). In Latin America, no securities regulator within Latin America has confirmed the accuracy of any information contained herein. The provision of investment management and investment advisory services is a regulated activity in Mexico thus is subject to strict rules. For more information on the Investment Advisory Services offered by BlackRock Mexico please refer to the Investment Services Guide available at www.blackrock.com/mx
Not FDIC Insured | May Lose Value | No Bank Guarantee
© 2022 BlackRock, Inc. All Rights Reserved. BLACKROCK, iSHARES and ALADDIN are trademarks of BlackRock, Inc. or its subsidiaries in the United States and elsewhere. All other trademarks are those of their respective owners.
BIIM0722U/M-2296573