The Trouble with Europe

September 23, 2022 |
3 minute read
|

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. 

Ryan Driscoll

Author

Ryan Driscoll

Managing Director

Disclaimer

Certain information contained herein has been obtained from or is based on third-party sources and, although believed to be reliable, has not been independently verified. Such information is as of the date indicated, if indicated, may not be complete, is subject to change and has not necessarily been updated. No representation or warranty, express or implied, is or will be given by The Common Fund for Nonprofit Organizations, any of its affiliates or any of its or their affiliates, trustees, directors, officers, employees or advisers (collectively referred to herein as “Commonfund”) or any other person as to the accuracy or completeness of the information in any third-party materials. Accordingly, Commonfund shall not be liable for any direct, indirect or consequential loss or damage suffered by any person as a result of relying on any statement in, or omission from, such third-party materials, and any such liability is expressly disclaimed.

All rights to the trademarks, copyrights, logos and other intellectual property listed herein belong to their respective owners and the use of such logos hereof does not imply an affiliation with, or endorsement by, the owners of such trademarks, copyrights, logos and other intellectual property.

To the extent views presented forecast market activity, they may be based on many factors in addition to those explicitly stated herein. Forecasts of experts inevitably differ. Views attributed to third-parties are presented to demonstrate the existence of points of view, not as a basis for recommendations or as investment advice. Market and investment views of third-parties presented herein do not necessarily reflect the views of Commonfund, any manager retained by Commonfund to manage any investments for Commonfund (each, a “Manager”) or any fund managed by any Commonfund entity (each, a “Fund”). Accordingly, the views presented herein may not be relied upon as an indication of trading intent on behalf of Commonfund, any Manager or any Fund.

Statements concerning Commonfund’s views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Fund. Such statements are also not intended as recommendations by any Commonfund entity or any Commonfund employee to the recipient of the presentation. It is Commonfund’s policy that investment recommendations to its clients must be based on the investment objectives and risk tolerances of each individual client. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund. Commonfund disclaims any responsibility to provide the recipient of this presentation with updated or corrected information or statements. Past performance is not indicative of future results. For more information please refer to Important Disclosures.

Stay connected with the Insights Blog

Popular Blog Posts


Market Commentary | Insights Blog

Chart of the Month | U.S. Budget Deficit Hits Record Highs

In his first 100 days as President of the United States, Joe Biden has introduced three domestic funding proposals, totaling close to $6.0 Trillion, reflecting a desire to enhance the role of the...
Investment Strategy | Insights Blog

Key Factors in Asset Allocation Decisions for Endowments

There are several broad subjects that an effective investment policy statement (IPS) should include in its contents and address clearly and specifically as they relate to an endowed institution. This...
Perspectives | Insights Blog

The Case for Using the Higher Education Price Index® (HEPI) to Define Inflation for Colleges

When calculating return targets for an endowment portfolio, a conventional piece of the equation is often the Consumer Price Index (CPI). CPI plus 5% is the common short-hand formula for institutions...

Disclaimer

Certain information contained herein has been obtained from or is based on third-party sources and, although believed to be reliable, has not been independently verified. Such information is as of the date indicated, if indicated, may not be complete, is subject to change and has not necessarily been updated. No representation or warranty, express or implied, is or will be given by The Common Fund for Nonprofit Organizations, any of its affiliates or any of its or their affiliates, trustees, directors, officers, employees or advisers (collectively referred to herein as “Commonfund”) or any other person as to the accuracy or completeness of the information in any third-party materials. Accordingly, Commonfund shall not be liable for any direct, indirect or consequential loss or damage suffered by any person as a result of relying on any statement in, or omission from, such third-party materials, and any such liability is expressly disclaimed.

All rights to the trademarks, copyrights, logos and other intellectual property listed herein belong to their respective owners and the use of such logos hereof does not imply an affiliation with, or endorsement by, the owners of such trademarks, copyrights, logos and other intellectual property.

To the extent views presented forecast market activity, they may be based on many factors in addition to those explicitly stated herein. Forecasts of experts inevitably differ. Views attributed to third-parties are presented to demonstrate the existence of points of view, not as a basis for recommendations or as investment advice. Market and investment views of third-parties presented herein do not necessarily reflect the views of Commonfund, any manager retained by Commonfund to manage any investments for Commonfund (each, a “Manager”) or any fund managed by any Commonfund entity (each, a “Fund”). Accordingly, the views presented herein may not be relied upon as an indication of trading intent on behalf of Commonfund, any Manager or any Fund.

Statements concerning Commonfund’s views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Fund. Such statements are also not intended as recommendations by any Commonfund entity or any Commonfund employee to the recipient of the presentation. It is Commonfund’s policy that investment recommendations to its clients must be based on the investment objectives and risk tolerances of each individual client. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund. Commonfund disclaims any responsibility to provide the recipient of this presentation with updated or corrected information or statements. Past performance is not indicative of future results. For more information please refer to Important Disclosures.