Fall in European economic risk

Fall in European economic risk

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The resilience scenario has its downside since it implies that the ECB would continue to raise interest rates.

While the consensus is for a recession this year, recent economic data shows clear European resilience. In the United States, things seem more confused, the labor market remaining dynamic while the purchasing manager indices (ISM/PMI) fell sharply. What is clear, however, is that inflationary pressures are easing, implying that the coming monetary tightening is already well within reach.

Which way does the balance lean?

According to the latest consensus forecast by Bloomberg, the probability of a recession within twelve months in the euro zone and the United States is very much higher than 50%. The arguments supporting this scenario are relevant, and the sharp fall in the services purchasing managers’ index in December (49.6) can only reinforce them. In such a scenario, US inflation would quickly be crushed and a new cycle would begin. In this hypothesis, the disadvantages of a recession for the equity markets (falling profits) would be more than offset by the renewed visibility that the fall in inflation and interest rates would provide. This is what happened during the recessions of 1974 and 1991.

If confirmed, the resilience scenario has its downside since it implies that the Federal Reserve and especially the ECB would continue to raise their interest rates in order to limit inflationary pressures on the labor market.

At this stage, however, a resilience scenario seems at least as likely. In any case, this is what the recent indicators suggest, which show a still positive dynamic in the American labor market without an acceleration in wages. It is therefore possible (but not certain) that the weakness of the survey data (PMI, ISM) reflects the end of the boom in orders linked to the reopening of the economy rather than a true recession. The next few weeks will therefore be crucial to see which way the balance tilts.

What is clear, however, is that the theme of the fall in European risk has been particularly strengthened by recent developments. The prospect of a winter without major shortages or bankruptcies and the drop in commodity prices led to a further rebound in economic confidence in December and a sharp drop in inflationary fears among households.

If confirmed, the resilience scenario has its downside since it implies that the Federal Reserve and especially the ECB would continue to raise their interest rates in order to limit inflationary pressures on the labor market. The risks associated with these tightenings are becoming more limited, however, as the markets have now fully priced in the foreseeable rate hikes for the coming months. The levels of 5/5.25% for the Fed rates and around 3.5% for the ECB rates correspond more or less to the latest indications provided by the members of the central banks.

In global funds, the rate of investment in equities must be increased by reinforcing the themes of lower European risk (small caps, financial stocks) and emerging markets. This, while continuing to earn monetary returns by very actively managing the cash portion of the portfolios. In European funds, the equity exposure rates are high and the beta of the portfolios has been increased in recent weeks.

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