European inflation and recovery on the continent
While all eyes have been on rising prices in the US and the UK, Eurozone inflation also rose to a record high of 5% last month - well above the European Central Bank’s 2% target. Food and energy prices, as well as supply chain bottlenecks, played their part in lifting it to a level not seen since the single currency was created more than two decades ago.
But the Eurozone is made up of many different economies. So will the figures released by Eurostat, the statistical office of the European Union, be enough to prompt interest rates to rise over the coming months?
Here we take a look at the main points:
Inflation drivers
In a similar story to the UK and US, the main inflation drivers during December came from energy, services, and non-energy industrial goods, as well as food, alcohol and tobacco, according to Eurostat.
Compared with November 2021, the annual inflation rate actually fell in seven member states, remained stable in two, but rose in eighteen*. The highest annual rates were recorded in Estonia (12%), Lithuania (10.7%) and Poland (8%), while the lowest were registered in Malta (2.6%), Portugal (2.8%) and Finland (3.2%)*.
No plans to raise rates
Christine Lagarde, head of the European Central Bank (ECB), has so far resisted calls for interest rates to rise in the belief inflation will gradually decrease as its main drivers start to ease. In an interview with France Inter radio, she predicted surging energy prices and supply chain bottlenecks would moderate over the course of 2022.
The following day, she took to Twitter and reaffirmed the ECB’s position. “Rising energy prices, supply bottlenecks and the strong recovery are driving inflation,” she wrote. “The conditions for @ecb to raise interest rates aren’t there yet. When they are, there’s no question in my mind that we will act.”
Divided opinion
However, Yoram Lustig, head of multi-asset solutions, EMEA and Latam at T.Rowe Price, pointed out the minutes of December’s meeting of the ECB’s rate-setting Government Council revealed divisions.
“The majority agreed that substantial monetary support was still needed for inflation to stabilise at the central bank’s targeted level in the next three years,” he said. However, it was not universal. “Some members warned that inflation might stay higher for longer and said they could not support the overall package of adjustments to the bank’s asset purchase programmes,” he added.
The view of economists
Despite inflation breaking multi-year records in the region, Mateusz Urban, an economist at Oxford Economics, believes headline inflation will be below the ECB’s target by the end of 2022.
“Our analysis suggests this year’s robust wage growth will moderate in 2023, with anchored inflation expectations and structurally high unemployment in parts of the bloc weighing on workers’ bargaining power,” he said.
However, he acknowledged the counter argument. “Should supply-side bottlenecks or high energy prices persist for longer, the risks of a permanent overshoot of the ECB’s inflation target would rise, which will translate into a higher chance of policy tightening taking place earlier than currently expected,” he added.
The impact of inflation
Even if headline inflation has already hit its peak, any drop in the rate is likely to be limited, according to Carsten Brzeski, global head of macro for ING Research. “Companies will continue passing through higher production costs to consumers,” he said.
“Consumers in some eurozone countries will only be charged higher commercial energy prices this year, and the end of the current lockdown measures is likely to spur price mark-ups.”
He believes such a combination will broaden inflationary pressure before any significant fall could take place. “Still, on the back of negative base effects and an end of some pandemic-related price mark-ups, we expect headline inflation to gradually come down in the second half of the year,” he added.
European recovery
The eurozone economy continues to recover, according to the ECB’s economic bulletin. “Growth is moderating, but activity is expected to pick up again strongly in the course of this year,” it stated. The report also highlighted how this ongoing economic recovery is expected to be driven by robust domestic demand.
While the economic recovery has boosted corporate profits, the hurdle for growth is now higher, according to Ben Moore, manager of the Threadneedle European Select fund. “Inflation has risen but interest rates remain under control, despite potential rises in the US,” he said. “Covid-19 and geopolitics (for example, with Russia and China) dominate sentiment.”
However, his focus remains on stock selection. “We seek to identify high quality companies with the pricing power to sustain strong returns,” he added.
John Bennett, manager of the Janus Henderson European Selected Opportunities fund, believes equities in the region will be influenced by whether or not inflation is transitory.
While he believes value stocks could dominate returns this year, he also warns investors to be prepared for – and accept – drawdowns in their investments. “I’m always amazed by how spooked people get on a 10% drawdown in equities,” he said. “It is part of the terms of engagement. This is what happens. Stay the course, just stay the course.”
One approach to get exposure to this region is by focusing on small and medium-sized businesses that are under-researched. That’s the focus of George Cooke, manager of the LF Montanaro European Income fund, whose largest country exposure is the 30% allocation to Sweden**. Its most prominent positions, meanwhile, include Swedish companies NCAB, which provides printed circuit boards, and Thule, the maker of outdoor and transportation products**.
*Source: Eurostat, Euroindicators, 20 January 2022
**Source: fund factsheet, 31 December 2021
Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. The views expressed are those of the author and fund managers and do not constitute financial advice.