A moderate H2 slowdown is now our base case for the euro area

Just as central banks keep rushing to tame the inflation beast, the energy crisis and political uncertainties are complicating their tasks even further. Yet both Equities and Bonds climbed a wall of worries in July (lots of bad economic news and rate hikes priced in). Still, the toxic combination of a deeper global slowdown and sticky inflation requires a prudent allocation stance, in our view.

Sticky inflation overshoots have left CBs far behind the curve, requiring a drastic catch up to fortify inflation credentials. With policies generally still accommodative, front-loaded rate hikes will continue over the summer.

Euro area recession looming for H2

Yet the inflation threat is only one part of the policy dilemma. Soaring prices alongside supply disruptions have severely blurred the economic outlook. We have propagated below-consensus growth forecasts for the euro area for longer, and now pencil in a moderate recession over H2. The US manufacturing slowdown is also spilling over to the rest of the economy, supporting our earlier view that 2023 growth will be below 1%, with the risk of a recession only slightly below 50%. The recession spectre will increasingly feed into central banks’ reaction function, keeping our expected CB rate paths below market pricing.

Once central banks start signalling that the tightening process is close to the end, we will feel more confident with rebuilding risk positions. But some more patience is required. First, CBs will need to see receding inflation rates before they can put more weight on growth weakness. Second, risks are tilted towards an even more toxic stagflation dilemma if the energy crunch in Europe deepens. EU natural gas prices have surged back to the dizzy levels seen in March on fears of sustained cuts in Russian deliveries. EU member states’ deal on gas savings will fall short of what is needed if Putin decides to turn off the taps. Political uncertainties in Italy do not help either. The right wing coalition is comfortably in the leads, but the weight of Brothers of Italy, and its not-so- friendly views towards EU policies, are a concern. Snap elections in September will also slow the reforms and may jeopardize the disbursement of NGEU funds.

We thus continue to favour a prudent risk stance, with an underweight in Equities and riskier (HY) Credit. We are also cautious on Southern European debt. The ECB’s new TPI will help to keep spread moves contained, but looks too discretionary – it is not clear if and when the hawks will ever agree that the spread moves are “fundamentally unjustified”. We keep our duration stance at near neutral (minor residual short), though we have been surprised by the pace of core yield retreat. We favour an overweight in IG Credit mostly on the attractive carry reached. The USD is dear, but still set to benefit near term from monetary policy divergence, global policy uncertainties and the European energy crisis.