SUMMARY
There is widespread evidence of declining business confidence across Europe and of spluttering goods exports. But the final phase of the adjustment has not begun yet as labor markets remain very tight and the export picture still shows positive, albeit very soft, growth.
Investor confidence at all-time low points to looming recession: Consumer and businesses are turning more pessimistic as we head into winter, with record high inflation, slowing demand and increasing costs. While government energy subsidies might limit the extent of the contraction, a recession is unavoidable in 2023.
High EU inflation and slowing real growth, not a great mix: Inflation hit all-time high of 10.7% YY but shows some signs of peaking this quarter. Real GDP growth will likely continue to soften and will probably turn negative before the end of 2022 and decline throughout the first half of 2023. The ECB is facing the arduous choice of hiking into a recession, likely bringing its policy rate to a broadly neutral level of 2% in December, with more hikes to come.
UK: Fiscal policy uncertainty will hopefully dissipate and rekindle investors’ appetite for gilts – PM Rishi Sunak, who replaced Liz Truss in late October, and Chancellor Jeremy Hunt are working behind the scenes to close the country’s £35bn fiscal gap. Markets have recovered from the tumultuous mini-budget announcement from former Chancellor Kwarteng, with sterling rebounding against the dollar and euro while gilt yields declined. For global investors, we stay underweight UK fixed income but see it as an investment opportunity for local investors.
Equity Outlook: The 3Q-22 earnings season started positively, but firms have begun to warn of tough times ahead and point to margin compression due to inflationary pressures. Most of the underperformance in Europe ex-UK equities has been mainly driven by an increase in real rates, slowing demand and growth. As we worry that earnings downgrades have yet to be incorporated into valuations, we remain underweight Europe ex-UK equities.
Special Feature: Is Europe Ready for Winter? Europe goes into the winter period with high storage levels and diversified supplies. The biggest unknown is the average level of seasonal temperatures. The much higher price of energy, lower levels of economic activity and efforts to conserve energy will also play a part in lowering demand. While further mutualization of debt issuance in the EU could be agreed to mitigate the cost of energy imports for the more vulnerable countries with higher funding costs, Europe still faces clear tail risks
