Subscribe to MarketScape
Why the ECB May Be Going Too Far
With European consumers already struggling with high energy bills, higher interest rates sparked by the European Central Bank may weigh too heavily on the economy. Chief Investment Strategist for EMEA and APAC Wouter Sturkenboom, CFA, analyzes the impact on European investments.
The European Central Bank sent a strong signal when it hiked interest rates by 75 basis points, taking a proactive stance in the face of elevated inflation. But with consumers already struggling with high energy bills, and a recession looming, the bank risks cutting into the economy too far with aggressive rate hikes. Let's take a closer look.
The most immediate and important impact of the ECB's hawkishness has been higher interest rates along the yield curve, up roughly 1% in six weeks and because inflation expectations actually declined during that same period, real yields, or yields less expected inflation, were the only driver behind the increase. This has created a material headwind for the eurozone economy and investors. Higher real yields make consumption and borrowing more expensive, acting as a brake on economic activity. And for investors, a higher real yield depresses the valuations of risk assets, eroding their returns.
Of course, to some extent, the ECB wants to slow down the economy by lowering demand and it wants to tighten financial conditions for investors. The risk is, however, that it simultaneously underestimates how much growth is already slowing down due to the energy crisis, and overestimates how long inflation will stay elevated. Under those circumstances, it is liable to hike rates too fast, too high, and keep them there for too long. We worry that that risk is increasing as the ECB's latest economic growth forecasts appear relatively high, as does its inflation outlook.
Investors have a tough combination of factors to consider in Europe, with a potential recession, elevated geopolitical risk, and now the increasing risk of over-tightening by the ECB. It also bears reminding that the lag with which monetary policy impacts growth and inflation, as well as the global backdrop of slowing growth and tighter monetary policy, exacerbates that risk. As a result, we expect longer-dated interest rates to come down modestly from current levels, and we maintain an underweight position in European equities.
