investment insights

    Eurozone navigates growth challenges as German motor stalls

    Eurozone navigates growth challenges as German motor stalls
    Bill Papadakis - Senior Macro Strategist

    Bill Papadakis

    Senior Macro Strategist
    Christian Abuide - Head of Asset Allocation

    Christian Abuide

    Head of Asset Allocation

    Key takeaways

    • Eurozone inflation has fallen largely thanks to lower energy prices. Gas inventories are close to full ahead of schedule, but the region is now dependent on the global market after successfully diversifying away from Russia
    • With the disinflation trend already in place and growth worryingly slow, we believe that the ECB has overtightened monetary policy
    • The region’s diversity offers some resilience: Spain has grown consistently for more than a year while Germany is in recession, yet weaknesses in the eurozone’s biggest economy are not triggering concerns for the euro
    • We see the euro rising to 1.12 against the US dollar within a year. We maintain a neutral position in European equities, and favour European investment grade credit over US issuance.

    Growth and inflation in the eurozone are slowing in response to a year of rapid interest rate hikes. Economic disparity across the region is a challenge for policy setting while avoiding recession as Germany, its biggest member state, slows. A concern remains that the European Central Bank (ECB) is overtightening its monetary policy.

    There was never a demand boom in the eurozone. The initial inflationary shock was about supply, rather than demand. The eurozone’s broad trend to slower price increases is now clearly in place with July’s inflation falling to 5.3% from 5.5% in June. Falling energy prices have been the main contributor to declining eurozone inflation, offsetting the continued rise in food and alcohol prices. The price of natural gas futures contracts rose last week on the threat of strikes in Australia, which supplies as much as one tenth of global liquefied natural gas (LNG). Europe has become increasingly dependent on the world market to meet its needs after cutting deliveries through pipelines from Russia. The price of LNG has fallen nearly ten-fold from the highs of one year ago and inventories are near full, months ahead of schedule. As a result, there are hopes that reserves will prove adequate for the region’s 2023/24 winter, although heatwaves across the continent are adding to demand for air conditioning.

    Economic growth across Europe has also slowed, with the region recording an expansion of 0.3% in the three months through June 2023, after zero growth in the first quarter and a contraction of -0.1% in the fourth quarter of 2022.

    This suggests that the ECB has already overtightened monetary policy

    Together with the disinflation trend in place, we believe that this suggests that the ECB has already overtightened monetary policy. The biggest immediate threat to the eurozone’s outlook is therefore a policy accident, as the central bank has raised its benchmark rate from -0.5% to 3.75% in the space of a year. There is room for the growth outlook to deteriorate further as higher borrowing costs filter into the economy. Such tightening has contributed to a fall in business confidence, even as, for now, consumer confidence is holding up thanks to tight labour markets (see chart 1).

    Read also: The foundations of a real estate revival

    Resilience in diversity

    For now, we see the euro area recording weak annual growth of 0.6% over 2023, with some acceleration to around 1% in 2024 as the job market remains strong and monetary policy eases next year. While that looks unimpressive at first glance, we should put this in the context of the uncertainties and fears of 18 months ago when Russia invaded Ukraine.

    The picture of an expanding eurozone economy obscures variances within the bloc (see chart 2). The Spanish economy has delivered GDP growth consistently of around 0.5% for more than a year, suggesting annualised growth of 2.1%, while Italy and Germany have both stalled. Germany’s growth is prompting angst at home about its longer-term outlook. GDP shrank in three of the four quarters through June 2023 and the economy may grow by 1.3% in 2023, its slowest pace since 2008. In response, the German government has started trying to change the country’s export-driven growth model that for decades relied on cheap labour and energy. After successfully slashing its dependence on Russian natural gas, Germany needs to address a projected shortage of workers and decades of underinvestment in its technological infrastructure.

    Chancellor Olaf Scholz is trying to improve Germany’s competitiveness in the semiconductor industry, and switch the economy to sustainable energy sources while attracting more foreign investment. But Russia’s Ukraine invasion has not only challenged Germany’s energy supply. In 2022, China became the world’s largest car exporter, shipping 3.2 million vehicles, out-speeding Germany’s 2.6 million. In part that is because China has increased car exports to Russia, but it also reflects investments in state-of-the-art electric vehicle batteries that powered China to producing more batteries than the rest of the world combined last year.

    Economic weakness in Germany is not triggering existential fears

    These issues would be challenging for any government to manage but for Germany’s three-party coalition, the combination is particularly testing. Opinion polls in July 2023 place Chancellor Scholz's SPD (Social Democratic Party) in third. That puts the SPD not only behind the CDU (Christian Democrats), Germany’s largest single party that was excluded from government by the three-party coalition, but also behind the right-wing AfD (Alternative für Deutschland) and raises the prospect of the far-right gaining further ground in regional elections.

    A decade ago the eurozone’s instabilities through the debt crisis prompted doubts about whether a single monetary policy was workable for all of the region’s economies, from Germany and France to the so-called periphery economies of Spain, Ireland, Greece and Portugal. Today, economic weakness in Germany is not triggering the same existential fears. That may suggest greater tolerance for disparities within the single-currency, or that no-one seriously considers an alternative.

    Read also: UK economic resilience offers mixed outlook

    Investment implications

    Our positioning on European equities remains neutral. We see a number of positive factors contributing to make eurozone equities attractive: cheap valuations and earnings expectations being revised positively – led by the financial sector and carmakers. There is also the potential support for earnings as rising interest rates contribute to better revenues in the financial sector and resilient commodity prices support energy and mining firms’ earnings.

    However, we cannot dismiss the risks to this rosier outlook: the ECB may further overtighten interest rates, and having shed its reliance on Russian natural gas, the region is now more exposed to international energy markets. Finally, the region’s trade flows remain highly exposed to China, where the economy is slowing.

    European corporate bonds look more attractive than their US-dollar denominated alternatives

    In European fixed income markets, we expect 10-year German Bund yields to decline slightly from their current levels of 2.65% over the next twelve months. We remain cautious on Italian government bonds, which we see at risk of underperforming given their relatively tight spread versus German sovereign debt, and as the ECB reverses bond purchases under its quantitative easing programme.

    Read also: Banking stress gives Fed pause. ECB’s job is not yet done

    European corporate bonds in turn look more attractive than their US-dollar denominated alternatives, since the US economy’s credit and monetary cycles are more advanced, and valuations are tighter after a July 2023 rally (see chart 3). In particular, European banks’ investment-grade bonds appear attractive compared with non-financial issues since yields increased in the first half of the year following banking stress and large issuance kept them under pressure. Within European high yield credit, improving economic momentum, strong corporate earnings, limited supply, and above all high absolute yield levels offer support in the short term.

    Turning to currencies, we expect the euro to trade at 1.06 against the US dollar three months from now, reflecting our anticipation of stronger US economic growth compared with the eurozone and higher US yields. Longer term, we expect a modest rise in the euro to 1.12 in a year, as the Federal Reserve moves closer to easing interest rates, and with EURUSD undervalued.

    Important information

    This is a marketing communication issued by Bank Lombard Odier & Co Ltd (hereinafter “Lombard Odier”).
    It is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful, nor is it aimed at any person or entity to whom it would be unlawful to address such a marketing communication.
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