Inflation moderates in Europe. Could this lessen short-term recession fears?

January 24th 2023

On the latest edition of Market Week in Review, Equity Portfolio Manager Olga Bezrokov discussed the recent global slowdown in inflation and the potential impacts on monetary policy. She also chatted about the Bank of Japan (BoJ)’s recent decision to widen the tolerance range for yields on its benchmark 10-year note and provided an update on the fourth-quarter earnings season.

Price pressures slow around the globe

Bezrokov kicked off the segment with a look at recently released inflation data from key developed markets. She said that the latest numbers from the eurozone, Germany, the UK and Canada all point to a moderation in inflation around the globe—helped in part by a drop in energy prices. Despite the deceleration, however, Bezrokov noted that inflation remains uncomfortably high in many regions—particularly in the UK. “In December, consumer prices in the UK climbed by 10.5% on a year-over-year basis—more than five times the Bank of England’s target of 2%,” she stated.

Bezrokov said that one bright spot in the more muted inflationary numbers is what they suggest for expectations around a deceleration in growth. “Producer prices coming down meaningfully in Europe could mean that the projected downturn may be more shallow than envisioned—and that the region might avoid a recession in the near term,” she explained. This is a meaningful improvement from several months ago when concerns were high that the eurozone and UK could face a prolonged recession, Bezrokov noted.

On the other hand, however, China’s economic reopening could also lead to increased demand for crude oil as consumption recovers, she said. “This could potentially push energy prices higher, as supply constraints stemming from sanctions against Russia remain in place,” Bezrokov remarked, noting that oil prices have been volatile since the start of the new year.

Central banks remain committed to restrictive monetary policies

The softening in inflation appears unlikely to sway global central banks from pivoting away from tight monetary policies for now, Bezrokov said. As proof, she pointed to recent remarks from European Central Bank (ECB) President Christine Lagarde, who told attendees at the World Economic Forum in Davos, Switzerland, that the central bank plans to stay the course on high-interest rates—and that inflation remains far too elevated.

“This is a signal that further rate hikes are still to come, and also that the ECB is committed to keeping rates high for a longer period of time, in order to bring inflation back to its 2% target,” Bezrokov stated.

Meanwhile, in the U.S., while interest rates are still expected to remain elevated for some time, early signs of differing opinions on the future path of rates are emerging, Bezrokov said. This is because inflation has been cooling faster in the U.S. than in Europe, and also because the U.S. Federal Reserve (Fed) has been more aggressive in raising rates, she noted.

“In the wake of weaker-than-expected U.S. retail sales data released on Jan. 18, two of the regional Fed governors, Lorie Logan and Patrick Harker, backed the case for moderating the pace of rate hikes, while another two, James Bullard and Loretta Mister, remained committed to the idea that restrictive policy is ‘not quite there’ yet,” Bezrokov noted. She added that despite the diverging comments, expectations remain for the Fed to lift rates once again at its upcoming Jan. 31-Feb. 1 meeting.

Bank of Japan defies expectations

Switching to the Bank of Japan (BoJ), Bezrokov noted that last month, the bank surprised global markets by widening its tolerance range for the yield on its 10-year government bond from 25 basis points to 50 basis points. This prompted speculation that the BoJ would abandon the ultra-loose monetary policy it’s maintained in order to stimulate the world’s third-biggest economy, she remarked. Since the change, yields have surged to the upper ceiling several times during the past month, prompting the central bank to deploy the equivalent of about 6% of Japan’s GDP (gross domestic product) to buy bonds and try to keep yields within the target range, Bezrokov noted.

“The BoJ’s defense of its stimulus framework in recent days is a rebuke of market speculation that it would adjust or abandon yield control measures,” she said, noting that the central bank left its interest rate unchanged at -0.1%—a level it’s been at since 2016—while reiterating that it will maintain its ultra-dovish policy, despite rising inflation in the country. Bezrokov added that BoJ Governor Haruhiko Kuroda, who will step down in April after 10 years at the helm of the central bank, further defended the commitment of the bank’s “extremely accommodative” monetary policy at the Davos Economic Forum.

The early read on Q4 earnings season

Bezrokov wrapped up the segment with a look at U.S. fourth-quarter earnings season, which is still in the early stages, with only 55 companies—or 13% of the S&P 500 market cap—having reported results. However, she pointed out that so far, 63% of reporting companies are beating expectations, with earnings surprising to the upside by 2.4%. “Should this beat rate continue, fourth-quarter earnings would only contract marginally—versus initial expectations for a 2.5% decline,” Bezrokov stated.

Outside the U.S., she said that earnings from companies in the MSCI EAFE Index are delivering stronger returns, supporting the outperformance of non-U.S. equity markets. “Right now, both sales and earnings are expected to grow at a 7.7% clip, compared to 4.2% for sales and -2.5% for earnings in the U.S.,” Bezrokov noted. However, she added that so far, EAFE companies are missing estimates by -3.2%, while U.S. companies are exceeding expectations.

Bezrokov concluded by noting that as earnings announcements continue, one important watchpoint for investors will be the projected reductions in headcount as companies attempt to support high margins. Case-in-point: On Jan. 20, Google parent Alphabet indicated it plans to slash 12,000 jobs—or more than 6% of its global workforce—this year, joining other big tech companies like Amazon, Meta, Microsoft and Twitter that have also recently announced job cuts.

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Source: Russel Investments

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