As U.S.-based investors, our clients tend to focus on issues closer to home when evaluating portfolio positioning. Most conversations are focused on the political climate, FOMC actions, localized discussions of the housing markets and, of course, overall economic activity in the United States. COVID was a global pandemic that, while lingering, has left much of the world working through the aftermath of the policies put forth to combat its repercussions. At the same time, the geopolitical upheaval of Russia’s incursion into Ukraine in late February complicated what would already have been a difficult post-COVID return to normalcy in Europe.
The currency markets and widening sovereign bond yield spreads indicate significant economic distress in the Eurozone. These market moves come as Europe is considering interventions in the energy market to address surging prices that threaten the region’s economies and put a significant strain on households. Europe is particularly vulnerable to the energy crises induced by Vladmir Putin’s invasion of Ukraine. Since the start of the war in Ukraine, Russia has cut gas supplies to the continent, sending power prices soaring. Should this trend continue as winter approaches, both consumers and industries would be at great risk.
The economic data is foreshadowing a difficult period for the European Union. Eurozone-wide consumer inflation rose to 9.1 percent year-on-year, from 8.9 percent in July. This was the 14th consecutive month that inflation has exceeded the European Central Bank’s target rate of 2 percent. The United Kingdom’s manufacturing data was once again in contraction territory as was the Eurozone’s. In Germany, manufacturing data continued to weaken as new orders showed a steep decline, albeit from historically high levels. On the energy side, prices in Europe have come off the highs as the European Commission President has called for ‘emergency intervention’ and as German gas storage levels are now able to accommodate approximately two months of consumption. Although energy price inflation slowed for the second month, there are increasing signs that inflation is spreading from energy to other components of consumer goods which can be seen in accelerating price increases for food, non-energy goods, and services.
European Central Bank inflation hawks have argued the central bank needs to raise rates into a looming recession to prop up the Euro, because the currency weakness feeds into inflation. The argument being made on the other side of the aisle is that Euro weakness improves Eurozone industrial competitiveness in an environment where manufacturing and industrial orders have collapsed. However, the European Central Bank sided with the hawks at the last meeting and hiked interest rates by a historic amount. Even with a weaker growth outlook and price increases primarily driven by supply factors, policy makers delivered a 75-basis point increase which was an unprecedented monetary-tightening step. President Christine Lagarde hinted it could do the same again as part of “several” future moves to attack rampant inflation. The decision highlights how hawkish policy makers dominate the 25-member Governing Council and emboldened by another overshoot in inflation that is more than four times the goal.
As the cost-of-living crisis reduces demand, it is largely believed a European recession will start this year. Higher borrowing costs are unlikely to blunt the soaring energy prices behind that spike. In the coming months, we believe the Eurozone economy is going to suffer increased demand destruction; first through a contraction in real incomes, and second through monetary tightening. Ultimately, businesses will pass on higher input costs, including higher energy costs, by raising prices for their products. In turn, this tends to lead to demands from workers for bigger wage increases to meet their higher living costs, in what can quickly develop into a runaway wage-price relationship.
It seems controlling inflation, no matter the economic cost, is the goal of global central banks. The Bank of England has signaled further rate hikes even as it predicts a five-quarter recession while the ECB delivered a rate hike despite the approach of winter and a cost-of-living crisis. And the FOMC has been clear it’s got further hikes to go and is quite content to accept a weakening economy. The challenge is that the global economy faces a divergence between the performance of these main economic contributors and China. The U.S. faces persistent overheating, and the FOMC will have to tighten further than it or the market expects. The European and UK response to the energy crisis is fiscal intervention, consumer subsidies, public funded investment, and monetary accommodation. At the same time, China is progressively easing to offset the effects of its zero-COVID policy and looming mortgage crisis. These different economic factors could continue to lend near term support to the increasingly stronger U.S. dollar.
Considering this, the U.S. may today be a more attractive option among the three highly challenged geographic regions. Unfortunately, to a great extent, this is already reflected in the relative valuations between the U.S. and the rest of the world. As a result, we believe that long term investment portfolios should continue to take a global approach. Global conditions are always changing, and this invariably creates longer term opportunities across regions even as current conditions remain unsettled. As part of our process, we closely monitor economic indicators that could signal how things will play out over various time spans and we take those into account in our Asset Allocation Committee decisions. Currently, we support a roughly target weight to Europe because, despite the obvious headwinds, experience tells us that turmoil is often the source of the most compelling investment opportunities.
