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The risk of stagflation in Europe has increased

The risk of stagflation in Europe has increased

The ECB will probably continue to normalise its monetary policy and raise rates through the autumn.
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30 AUG, 2022

By Capital Group


It is too early to say European inflation has levelled out. The upward pressure on energy prices is going to push out the peak to the autumn at the earliest. Latest data has confirmed a broadening of inflationary pressures (top chart), and companies are able and willing to raise their selling prices to protect profit margins. While wages have so far remained subdued, there are upside risks given tight labour markets, higher energy prices and a continuing inflation overshoot.

Energy supply disruption remains a substantial downside risk. Russia is restricting gas supply to Europe, curtailing countries’ ability to build up gas storage ahead of the winter and raising the prospect of demand rationing in the coming months. A severe disruption to energy supplies from Russia could trigger a deep recession in Europe's major economies, along with raised inflation.

The challenges for the European Central Bank (ECB) are clear: bringing down inflation while avoiding a recession and fragmentation in sovereign bond markets. The ECB will probably continue to normalise its monetary policy and raise rates through the autumn. However, a complete cut-off of Russian energy imports would represent a huge and persistent negative supply shock to the European economy, likely causing the ECB to curtail policy tightening. A substantial fiscal response to support the most vulnerable households and companies would also become more likely.

We remain cautious on European fixed income markets. We continue to be underweight interest-rate risk in European government bonds, although we increased German bund duration over the second quarter as the downside risk has increased. We are underweight France and Italy, due to less technical support from the ECB, and overweight Germany since it is likely to offer some downside protection if Russian energy supply stops. While remaining underweight European credit risk, certain areas such as the senior banking debt now look attractive given wider spreads (bottom chart), as well as banks’ strong capital position and their ability to absorb a potential increase in non-performing loans.

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