Beware the European optimism trap

The writer is a former chief investment strategist at Bridgewater Associates

The European Commission’s consumer confidence index could be seen as an economist’s attempt at dark humour — since it was launched in the 1980s, the gauge has always been negative, with fluctuations just reflecting relative shades of gloom.

While the commission’s index suggests that eurozone consumers today are only modestly downbeat (with a level of minus 19 points in February compared with minus 29 last September), other reflections of Europe’s macro picture have become positively sunny.

Europe’s double-digit equity market returns so far this year are handily outpacing developed-market peers. Meanwhile, economic data has sharply surprised expectations to the upside. Only months ago, most forecasts assumed a 2023 recession.

The growing risk today is that investors simply assume these trends will continue. While that’s always possible, the positive macro and market forces are likely to fade as the year progresses. For those investors who have benefited from strong gains this year, it makes sense to consider taking some profits off the table, for at least four reasons.

First, the bump in economic activity from China’s reopening after Covid-19 lockdowns is likely to prove a one-off rather than a sustained support for European growth. With Asia now representing more than 20 per cent of Euro Stoxx 600 revenues, according to JPMorgan, and China alone around 10 per cent of overall European exports, it is no surprise that the pent-up Chinese demand is helping European equity sentiment and regional activity.

But in contrast to much of the developed world, where a post-pandemic splurge in spending was reinforced by large fiscal transfers, Chinese consumers seem likely to quickly revert to a more cautious stance. They face uncertainty around the critical property sector that is the basis of much Chinese household wealth creation. At the same time, the government remains intent on pursuing policies to support the economy over the longer-term versus short-term “floods” of liquidity-fuelled growth.

Second, the monetary backdrop in Europe will be getting significantly tighter at a time when global liquidity is also being withdrawn. A run-off of the European Central Bank’s bond portfolio is set to begin this month. And given growth is resilient and inflation remains multiples above the central bank’s target, there is likely to be a continuation of rate rises to take monetary policy further into restrictive territory. The ECB is “catching up” to the Federal Reserve — with the impact of the tightening ahead to be increasingly felt as 2023 progresses.

Third, and part of the ECB’s challenge, will be the direction of natural gas prices, which remains highly uncertain. The region clearly benefited in recent months from milder than expected winter weather and business efforts to limit gas consumption.

That has led to high storage levels and influenced a sharp fall in prices. Benchmark wholesale gas prices in late February tipped below €50 per megawatt hour, their lowest level since September 2021 and a fraction of the all-time high of €320 reached last August.

Still, prices remain well above prewar long-term averages, and there is a wide cone of possible outcomes for prices this year as countries seek to replenish reserves. Will Russian gas deliveries fall further? How much will China compete for supply? This is not a macro support one should count on.

Fourth and finally, Europe — like the US — has a potential fiscal fight in store this year. The region’s stability and growth pact that requires fiscal prudence was suspended in 2020 but is set to come back into force in 2024.

There is hope that reform of the fiscal rules could help ease government burdens, especially for more indebted countries such as Italy where the debt-to-GDP ratio has risen to nearly 150 per cent (versus the bloc’s 60 per cent long-term target).

For now, though, there are proposals but no agreement. It’s reasonable to expect this to come to a head over the summer (possibly sharing headlines with US debt-ceiling deadlines) so any new framework is resolved in time for year-ahead budgetary discussions.

Even with modest reforms and potential economic support from the ECB through its transmission protection bond-buying instrument, probable fiscal belt tightening next year will coincide with higher interest rates and less external growth support from China and the US. That seems highly probable to get many investors in Europe gloomy again.