Wei Li, Global Chief Investment Strategist at the BlackRock Investment Institute together with Alex Brazier, Deputy Head, Beata Harasim, Senior Investment Strategist and Nicholas Fawcett, Macro Research, all forming part of the BlackRock Investment Institute, share their insights on global economy, markets and geopolitics. Their views are theirs alone and are not intended to be construed as investment advice.
Energy shock: We think the energy crisis will spur a recession in Europe. The ECB is trying to fight inflation without recognizing the costs. We prefer credit over equities.
Market backdrop: The ECB raised rates by a record 0.75%. We think the ECB will keep raising rates through year-end until the economic effects of the energy crunch are clear.
Week ahead: All eyes are on U.S. CPI inflation for signs of further easing, especially core inflation. We expect inflation to cool but still settle above pre-Covid levels.
The energy crunch will drive a recession in Europe, as we’ve argued since March. The crisis has worsened since then as Russia has halted gas supplies. Plus, the European Central Bank (ECB) isn’t acknowledging how it will crush activity further by trying to fight high inflation, in our view. We think the ECB will wake up to this reality sooner than markets expect – but not before it inevitably faces a severe recession. We remain underweight equities and prefer high-quality credit.
Europe’s energy squeeze
Europe’s efforts to wean itself off Russian energy have triggered a price surge that’s been amplified as Russia cuts gas supplies. The European Union is now spending nearly 12% of its GDP on energy, making the crisis worse than the 1970s oil shocks. See orange line in the chart. That’s not the case for the U.S, a net energy exporter (yellow line). It’s hard to see any relief for Europe in the next couple of years, with rationing on the horizon, in our view. Winter may cause demand to surge, slashing stockpiles. Countries are rushing to cushion pressure, especially on households. Germany plans to collect excess profits from energy providers and cap prices. EU energy ministers have called for similar policies. The UK has a sizable plan to pay energy suppliers the difference between a new capped price and the price they would have been able to charge.
The euro area policies are much smaller than those in the UK or for Covid-19. That reinforces why the energy shock will drive a protracted recession lasting several quarters in Europe, in our view. The ECB is set to make things worse: Like the Federal Reserve, the ECB hasn’t acknowledged the damage it must do to growth to fight this inflation, even after it hiked a record 0.75% last week. The ECB is instead responding to the politics of energy-driven headline inflation, we think. Its new forecast for modest growth next year is already stale by not accounting for recent events like Russia cutting off gas supply. We see the ECB’s downside scenario of a -0.9% contraction as more likely. The euro sliding to 20-year lows against the U.S. dollar reflects deteriorating growth and terms of trade from higher energy prices, in our view.
European Central Bank view
The ECB will also have to contend with fragmentation risks – and perhaps put into practice its anti-fragmentation tool for peripheral debt spreads. Italy’s economic fundamentals have worsened in this shock, with the shift to a current account deficit amid its heavy debt burden. That’s more likely to feed volatility for Italian bonds, even if the coming election likely results in a center-right government that won’t be very antagonistic to the EU.
We think the ECB will keep up its aggressive rate hikes through the end of 2022 but then stop once it sees the economy taking a major hit. Year-end rates will likely stand somewhat short of current market rate expectations, in our view.
Bank of England view
Unlike others, the Bank of England (BoE) has been clear that bringing inflation down to target would require a deep recession. The UK’s fiscal plans wouldn’t change that, in our view. The measures are just another example of governments responding to the politics of high inflation. The subsidies may slow headline inflation and cushion the recession blow in the near term. But they can’t solve the imbalance of low supply relative to demand – and in fact block the fall in demand required to reduce inflation. Limiting the hit to real household incomes reduces the growth drag the BoE would have expected. That implies the BoE will keep hiking rates to get demand back in line with supply but not as much as markets expect, in our view.
Our bottom line
European stocks aren’t priced for the deep recession we expect. Excluding commodities, European earnings growth estimates are too optimistic, we think. We stay underweight European and most developed market stocks. We prefer investment grade credit as yields better compensate for default risk. We’re neutral European government bonds and have a modest overweight to UK gilts with a preference for short-dated bonds due to markets pricing in an overly hawkish rate path.
Volatility persists across markets – underscoring the new regime of heightened macro volatility. The ECB hiked rates a record 0.75% and cut its growth forecasts last week. Yet the ECB’s new growth forecasts still don’t reflect the deep recession we expect from the energy shock and higher rates. We see the ECB jacking up rates through year-end but then stopping as the economic toll from the energy shock and rate hikes becomes clear.
The focus this week is on whether U.S. core inflation is slowing further or staying at elevated levels. The consensus sees the core CPI holding fairly steady, up by shelter costs, even if headline inflation likely cools on lower gasoline prices. The Bank of England policy meeting previously set for Sept. 15 has been rescheduled after Queen Elizabeth’s death.
Sept. 12: UK GDP data
Sept. 13: U.S. CPI data
Sept. 14: UK CPI data
Sept. 16: China retail sales; U.S. University of Michigan survey
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