How to capitalise on disinflation in Europe - 5 June 2023
Disinflation seems to be well under way in Europe, albeit a few months behind the United States. This is good news, but which assets will benefit most?
Triggered by a reduction in energy prices (-14% since the highs of October 2022), European disinflation has now reached the food and industrial goods sectors. In May, annualised eurozone inflation over six months was +2.5% (cf. chart 1). Excluding energy and food prices, the rate remains high (+5%) but is finally beginning to fall. The drop in energy prices should continue to spread, and that should in turn lower this underlying inflation.
In theory, this disinflation should be beneficial to sovereign bond markets. After all, lower inflation amid an economic slowdown should prompt the ECB to soon stop putting up interest rates and to start to lower them next year. However, there are two spanners in the works.
First, the bond markets have already largely anticipated both the disinflation and its expected impact on ECB policy. In the inflation-linked bond market, the eurozone break-even inflation rate is already close to 2% for the next two years. Moreover, the yield curve is clearly inverted (cf. chart 2), which betrays expectations that interest rates will fall from the start of next year. Lastly, real interest rates (which take expected inflation into account) remain very low in Europe (they are zero in Germany), which we do not believe to be very attractive.
As such, betting on eurozone sovereign bonds requires a belief that forecast inflation will soon dip below 2% and/or that a recession will force the ECB to cut its interest rates sharply. While not being beyond the realms of possibility, such a scenario is threatened by the second spanner in the works. Rapid disinflation should be beneficial for eurozone purchasing power and therefore consumption (which is currently low). This would make the recession scenario less likely and mean the ECB could keep interest rates above 3% for longer than currently anticipated by the market.
Were this to happen, short-term money market securities (negotiable debt securities, or TCN), whose yield more or less tracks the ECB rates, would continue to display a much better reward-to-volatility ratio than sovereign bonds (cf. chart 3). The average three-month TCN yield is currently in excess of 3.5%, versus 2.75% for two-year German bonds.
We therefore believe that sharp disinflation in Europe does not significantly increase the appeal of sovereign bonds when allocating assets. First and foremost, the role of these bonds is to be a safe haven during a recession, something made less likely by disinflation.
Rather than government bonds, it is those European equities that are particularly sensitive to domestic consumption that may pique investors’ interest. In any event, we expect European disinflation to assuage fears of an excessive economic slowdown, fears that have caused European markets to underperform over the last few weeks. Lastly, disinflation reduces the risk that the ECB will become very aggressive and bring growth screeching to a halt.
Our global funds retain equity allocation of 20% for the prudent strategy, 40% for the balanced strategy and 100% for the long-only fund. The equity pocket is invested in an extremely diverse core basket of 200 stocks and in two complementary themes (Green Deal and defensive). Our bond duration remains at zero due to the high prices and volatility of the sovereign debt markets. We are continuing to earn increasing returns on the non-equity portion, via money market securities (TCNs) issued in the eurozone.