BlackRock’s Weekly Market Commentary: ECB may limit hikes as recession nears

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.

Chart of the week

Euro to U.S. dollar

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.

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 an d 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 does this mean 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.