Investors are increasing bets Europe will sink into a painful economic downturn, in a growing contrast to the conviction in financial markets that the US is headed for a “soft landing”.
The euro has fallen against the dollar over the past two weeks, while the surprise ascent of European shares this year has stalled, and German government bonds — investors’ preferred retreat in times of stress — are gaining in price.
The shifts show growing confidence among fund managers that economic indicators in the eurozone are weakening in the face of higher borrowing costs, while the US has demonstrated resilience despite the most restrictive interest rate environment in 22 years.
“We’ve seen a lot of interest rate hikes in the US, but demand and growth are strong,” said Ario Emami Nejad, portfolio manager at Fidelity International.
“The European growth dynamic is weak; we think the [European Central Bank] has made a policy mistake and they will recognise this late,” he added, referring to the idea that the ECB has hoisted borrowing costs too high and will be forced to cut them.
Official figures last week showed the US economy grew at an annualised rate of 2.4 per cent in the second quarter, well above what economists had forecast, while the US Federal Reserve’s preferred gauge of inflation cooled more than expected in June, bolstering expectations it can soon call time on its rate-raising cycle. Meanwhile, Europe has been teetering on the brink of recession, while services inflation in the eurozone hit a record of 5.6 per cent in July.
Analysts said interest rate rises had been less successful at bringing down inflation in Europe than the US, because a larger proportion of inflation had been down to the damage inflicted in food and energy supplies by Russia’s all-out invasion of Ukraine.
In the first half of this year, European equity markets were a surprise hit, confounding analysts’ almost universal expectation of declines. Instead, a relatively mild winter and easing of the region’s energy crisis helped the continent to avoid a deep shock, and propel the Stoxx Europe 600 index 8.5 per cent per cent higher in the first six months of the year.
Those gains have gone into reverse midway through a disappointing second-quarter earnings season. Companies on the Stoxx 600 are on track to deliver their biggest decline in quarterly profits since the early stages of the Covid-19 pandemic, reporting a 17 per cent year-on-year drop in earnings per share in the second quarter, more than double the fall of US rivals in its benchmark S&P 500.
Accordingly, the share price gap with Wall Street has widened. The S&P 500 is up almost 20 per cent this year, helped in part by enthusiasm over artificial intelligence — an area dominated by US companies.
“If you look at the equity valuations, they’ve been much higher in the US than in Europe and the rest of the world for quite some time,” said Tim Murray, a multi-asset capital markets strategist at T Rowe Price. “There was a little bit of narrowing and now that’s widened back out. In the US, the narrative is we’re going to get the soft landing and avoid recession”, he added, “whereas I think in Europe, there’s still a lot of doubt about that.”
The picture is similar in other parts of the financial markets. The euro has fallen 2.6 per cent against the dollar since mid-July, and in government bonds, the gap between US 10-year borrowing costs and those of Germany — Europe’s biggest economy — has widened to its highest level this year.
That so-called spread hit its narrowest point since 2014 in April this year, but has since expanded as US economic data improved relative to the eurozone, hitting 1.6 percentage points on Wednesday.
Kevin Thozet, a member of the investment committee at Carmignac, said that dynamic had pushed him to offload some US Treasuries in favour of German government bonds, which would rally in the event of a full-blown European recession. “When we consider the two economic blocs, Germany is the region where we see the most economic weakening,” he said.
Figures from BNY Mellon, custodian to about a fifth of the world’s financial assets, show non-US investors have made net sales of about $50bn of US Treasuries since the start of the year, while Bunds have attracted close to $4bn of net inflows from non-eurozone investors over the same period.
Investors have also been buying UK government bonds in recent weeks, with 10-year gilt yields falling 0.25 percentage points from a peak in early July, as investors bet aggressive rate rises from the Bank of England to deal with the UK’s outsize inflation problem would soon result in economic pain.
“We are more positive on gilts than we have ever been,” said Eren Osman, managing director at the private bank Arbuthnot Latham. “If you believe there will be a recession, government bonds are the asset class you want to be in.”
The price of bonds issued by companies also show expectations of a rosier outlook for the US over Europe. The premium paid by lowly-rated US companies to issue bonds is hovering around its lowest in 16 months, with the “spread” over government debt standing at 3.82 percentage points — down from 4.81 percentage points at the end of 2022.
Eurozone junk bond spreads remain much wider, having shrunk by a more modest 0.7 percentage points to 4.32 percentage points this year, according to the ICE BofA Euro high-yield index.
Additional reporting by George Steer
Source: Economy - ft.com
