By Tomasz Wieladek, chief European economist at T. Rowe Price
Forecasting a stock market correction with any degree of confidence is clearly very hard to do. However, the European macroeconomic environment is increasingly becoming conducive to one. Macro weakness, tighter financial conditions, draining liquidity, and dampening investor sentiment all suggest the probability of a correction is rising.
Services PMI has been highly correlated with moves in the Eurofirst 300, and the European economy will continue to weaken. According to surveys, manufacturing PMIs are already very weak, with readings below 40 in Germany. The Euro Area Services PMI remains only just in expansion, but I believe it will move firmly into contraction territory within the next three months. If this was the only fundamental that mattered – it clearly is not – the Eurofirst 300 would already be down significantly from current levels. While it is possible August’s services PMI moves up slightly tomorrow, I would attribute this to seasonality.
Tightening financial conditions point to a more challenging environment for the European stock market. One measure of financial conditions in the euro area is the 10-year bund yield, a reflection of the ECB’s monetary policy tightening. Bond and equity prices both moved lower during most of 2022, but equity prices have rebounded and decoupled from bonds this year. Only time will tell if this decoupling is persistent or temporary. In the meantime, the majority of inflation and real economy data point to a hike by the ECB in September, which will likely continue to keep financial conditions tight for the foreseeable future.
Investor sentiment and the ECB’s rapid draining of liquidity add to the challenging equity backdrop. Sentix euro area investor expectations are reasonably well correlated with euro area share prices and imply a correction. Unlike other major central banks, in addition to QT, the ECB’s TLTROs are also expiring. Over the next 12 months, the ECB’s balance sheet will shrink by €775bn, or 5.8% of GDP. Such a large contraction in base money has been historically associated with the recession in the euro area.
The large expansion of the ECB’s balance sheet, and the associated portfolio rebalancing and search for yield, have been very supportive for European equity prices over the past couple of years. But the ECB is now reducing its balance sheet quickly and we are seeing a drastic reversal of this supportive environment. This tightening macro-financial environment will impair the effects of any catalysts to the European stock market going forward.
