LONDON/WASHINGTON, Feb 7 (Reuters Breakingviews) - Breaking up is hard to do. Yet after matching each other step for step while tightening monetary policy over the last six months, U.S. Federal Reserve Chair Jerome Powell and his European counterpart Christine Lagarde are parting ways. The fragile state of the American economy and the euro zone’s surprise resilience could leave the European Central Bank as the lone hawk among major rate-setting institutions. Investors can benefit from the split by favouring the euro and European equities.
The pivotal recent day for central bank watchers was July 21, 2022. That afternoon the ECB approved the first increase in the official cost of money since 2011. In doing so it joined the Fed, which had begun raising rates in March, in the fight to bring inflation down to the 2% target maintained by both institutions.
Each subsequent rate-setting meeting chaired by Powell and Lagarde brought another increase, accompanied by muscular statements about the “pain” to be inflicted on households or the need for “restrictive” policies. Financial assets suffered on both continents. The S&P 500 Index (.SPX) of leading U.S. stocks dropped by a fifth, including reinvested dividends, in 2022, while the STOXX Europe 600 (.STOXX) benchmark lost more than 10%.
Last week, though, the transatlantic two-step ended. Though both central bankers once again hiked rates, the economic backdrops were different. After lifting the Fed funds rate by 25 basis points, Powell characterised recent declines in the rate of inflation as “most welcome”, and talked of a “path” to beating rising prices without a recession or much higher unemployment.
The change of mood comes as the U.S. economy is showing signs of buckling. Consumer spending fell in December by the most in nearly two years. And while hiring unexpectedly boomed in January, it has slowed in five of the past six months.
Meanwhile the ECB pushed up its deposit rate by 50 basis points, and promised a hike of the same magnitude in March and to keep going after that. Traders now expect rates in the euro area to reach 3.5% in June and stay there until at least February 2024, according to Refinitiv data. Meanwhile, the market is betting that U.S. rates will peak at 5%-5.25% in May and start falling in November.
This discrepancy is partly because the two central bankers started from different positions. Not only did the ECB delay tightening until four months after the Fed, it also had to lift rates from the sub-zero depths they reached in 2014, after the euro zone debt crisis. Powell’s head start also means the United States is closer to getting inflation under control. The Organisation for Economic Co-operation and Development reckons American prices will rise 3.9% this year, compared with 6.8% in the euro zone.
Yet the European economy is also proving surprisingly resilient. Euro zone GDP grew by an unexpected 0.1% quarter-on-quarter in the last three months of 2022, bringing overall output growth to 3.5% last year. A fall in gas prices, a mild winter and generous government help for households, plus the speedy reopening of its key Chinese export market, have reduced the odds of a recession in 2023.
By contrast, the U.S. outlook remains gloomy. A UBS analysis of economic data for the two blocs puts the probability of output in the United States contracting at 100%. The same indicator for the euro zone has dropped to 26%, from 60% in October. Of course, inflation’s path is highly uncertain and either central bank could change course. Moreover, the ECB could still tip the euro zone into a recession.
So far markets have ignored these darker scenarios, focusing on the possible end to the rate-hike cycle. The S&P 500 Index is up 8% since January, including reinvested dividends, while the STOXX Europe 600 Index has risen by 7%. Yields on 10-year U.S government bonds have dropped by 17 basis points to 3.62%, while equivalent German sovereign debt yields 2.29% – 15 basis points less than at the start of the year.
Diverging economic and monetary paths mean this “everything rally” is unlikely to last. The most natural winner will be the euro. The day before the ECB started hiking last July the interest-rate gap between the two blocs – a key driver of foreign exchange rates – was 225 basis points. By November it could be down to 150 basis points.
In part, markets have already priced in this trend. In the past three months, the single currency has gained 7% against the U.S. dollar and now trades at around $1.07. However, Deutsche Bank analysts expect it to hit $1.15 in 2023. A stronger euro would keep a lid on import prices, reducing the need for further rate rises.
The case for buying European stocks is less straightforward. U.S. equities have benefited from expectations that interest rates will soon peak. However, a recession would dent both corporate earnings and investor confidence. Research by Longview Economics shows that no U.S. bear market – a 20% fall in equities from peak to trough – has ended before economic output shrinks.
European stocks are also cheaper. Companies in the STOXX Europe 600 Index trade at 13 times expected earnings for the next 12 months, well below the 18 times of the S&P 500 Index, according to Goldman Sachs. That discount is nearly a quarter larger than the long-term median.
Moreover, European companies stand to benefit from an improving global economic outlook because around 60% of their sales come from abroad, Goldman reckons, compared to around 40% for the largest American groups. European stock markets are also more skewed towards lower-valued companies – such as financial, industrial, energy and consumer firms – that tend to pay higher dividends and usually lead the way when the economy improves because their earnings are more sensitive to business cycles.
As Powell and Lagarde go their separate ways, investors will increasingly be drawn to the lone European hawk.
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CONTEXT NEWS
The U.S. Federal Reserve on Feb. 1 raised its benchmark overnight interest rate by 25 basis points to a range of 4.50%-4.75%, its smallest hike so far of an 11-month tightening cycle.
On Feb. 2 the European Central Bank increased its key rate by 50 basis points to 2.5%, its fifth successive hike. The deposit rate is now at the highest level since November 2008. The ECB said it intended to hike the rate by another 50 basis points in March to bring inflation down to its 2% medium-term target.
