There is considerable uncertainty around the depth and duration of a likely recession in Europe this winter. A significant slowdown is underway, with slumping consumer confidence and weaker business sentiment in retail and industry. Higher energy prices are eroding real incomes and curbing consumer spending, while rising labour and energy costs are squeezing corporate profit margins. Governments are providing fiscal support to insulate households and companies from the energy shock, but this could come at a substantial budgetary cost. A full cut-off of Russian energy exports could lead to a deeper recession and force rationing in some economies.

The European Central Bank (ECB) appears more confident that the eurozone’s economy will weather the energy price shock better than it initially expected, with substitution of other energy sources and fiscal support expected to limit the damage to the real economy while sustaining higher inflation. Despite considerable uncertainty, the ECB will likely continue to tighten monetary policy to return inflation rates to neutral as quickly as possible and this is partly priced into markets.

Indicators of underlying inflation have risen, reinforcing the ECB’s worries about upside risks to medium-term inflation prospects. Recent consumer price index data have shown a broadening of inflationary pressures. Non-energy industrial goods prices have been particularly strong, and services prices have increased more significantly as economies have re-opened.

We remain cautious on European fixed income markets and are underweight duration. While we are overweight German bunds (which are more attractively valued after the recent sell-off and would provide a degree of downside resilience in the event of a recession), we are underweight countries such as France and Italy, which will receive less technical support from the ECB’s asset-purchase programme. Selective opportunities remain, including Danish covered bonds, which provide attractive valuations and strong fundamentals, although we have reduced our exposure given the impact from rates volatility. We have also become more constructive on select high-quality corporate bonds, particularly in the banking sector, where spreads on senior debt have become more attractive. 

Eurozone inflation

Data as at 30/09/2022. Core inflation excludes food, drink, tobacco and energy.
Source: Bloomberg

Forecasts shown for illustrative purposes only.

Expectations of future eurozone interest rates have risen sharply

Data as at 11/10/2022. US forecasts based on Fed funds rates, UK and Eurozone forecasts based on Blomberg consensus. Sources: Bloomberg, Capital Group

Forecasts shown for illustrative purposes only.

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