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What is happening with inflation in Europe?
Investment in Europe

What is happening with inflation in Europe?

ECB faces a serious policy dilemma, between inflation and possible recession in the face of dwindling Russian gas supplies and energy rationing.
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1 JUL, 2022

By Federated Hermes


The experts at Federated Hermes analyse euro area inflation data released this week and indicate that inflation "continues to head towards a peak of 8.5% (or higher) in the third quarter of this year and is likely to remain at elevated levels until the end of the year".

Regarding the ECB's upcoming announcements, they believe that the ECB "faces a serious policy dilemma", between inflation and possible recession in the face of dwindling Russian gas supplies and energy rationing.

As for market performance, while the more optimistic are saying that the market is approaching more reasonable valuation levels, the experts remain "cautious about the reliability of earnings estimates" and believe that, while earnings season will clear up the unknown of whether prices are ahead of expectations, "it may also generate significant volatility".

Silvia Dall’Angelo, Senior Economist at Federated Hermes Limited

Inflation numbers out of the main euro zone countries for the month of June were a mixed bag but on balance pointed to a further deterioration in the inflation picture. Spanish inflation reached double-digit territory at 10% in June, and French inflation also climbed to 6.5%, from 5.8%. German inflation bucked the trend, as it declined to 8.2%, from 8.7%, but it remained uncomfortably elevated, with the decline this month probably reflecting some temporary policy measures that are meant to reduce gasoline and public transportation costs over the summer.

Overall, euro zone inflation is still heading towards a peak of 8.5% (or higher) in the third quarter of this year and is likely to remain sticky at elevated levels through year-end. Provided there is no additional shock, inflation should come down quickly over the next year, as stabilisation in commodity prices (and related base effects), easing supply constraints and a demand slowdown should all provide downward pressures. 

The ECB faces an acute policy dilemma. On the one hand, high inflation for a protracted period risks becoming entrenched via expectations and/or wage formation processes. On the other hand, the recent decline in gas provision from Russia raises the prospect of energy rationing in the autumn, which would likely lead to a recession. As suggested by ECB officials during the Forum on monetary policy in Sintra, the central bank will focus on policy normalisation for now, with a view of leaning against the risk of second-round effects. A 25bp rate hike in July is a done deal and a larger 50bp move might follow in September. However, data-dependency, conditionality and flexibility will inform the normalisation process going forward, amid elevated uncertainty and pronounced downside risks.

James Rutherford, Head of European Equities at Federated Hermes Limited

European equity markets have been buffeted by increasing concerns over Russian gas supply, and the prospect of industrial plant shutdowns and energy scarcity in Germany has weighed heavily on shares in the industrial sector. With some proverbial babies being thrown out with the bathwater, we see some opportunities among them. For instance, in recent weeks the German gas worries have caused the shares of Brenntag, a German-listed distributor of chemicals, to significantly underperform the market despite Germany accounting for less than 15% of group revenue. Brenntag is a defensive business that generates strong free cash flow in recessionary times, and the company recently significantly increased its full-year profit guidance. We are holders of Brenntag in our portfolios, and believe the shares are undervalued.

Lewis Grant, Head of Global Equities at Federated Hermes Limited

After a brief lull, the downward trend has continued. Investors have alternated between fears of inflation and fears of recession, but we must not ignore another possibility: why not both? Neither inflation nor recession is a positive for equity markets; stagflation would be particularly challenging. As the first half of 2022 draws to a close and equity markets are again a sea of red, it appears investors share our concerns. 

And yet the week started more optimistically, with growth stocks leading equity markets higher. Bullish commentators highlighted how earnings expectations have not fallen in line with prices, and while sentiment is weak the market is approaching more reasonable valuation levels. There may be merit in this view, however we remain cautious on the reliability on earnings estimates. The global economy teeters on the brink of recession and history tells us that when things become difficult, prices tend to move ahead of expectations. The effects of elevated inflation, falling consumer sentiment and China’s Covid shut-down are challenging to forecast: the forthcoming earnings season is likely to bring clarity to some of these unknowns, but may also drive significant volatility.

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