The question is: what to do next?
The first point I’d like to make is that valuations of European cyclicality are still near all-time cheapness, and likewise, ‘Quality’ is still near most expensive (Figure 1). Therefore, inflation beneficiaries remain compelling to own based on valuations alone.
Secondly, Jerome Powell runs the Fed – not the European Central Bank (ECB). Arguably, the tipping point for the Fed to pivot was the labour market and wage inflation. The combination of the great resignation and output gaps closing has led to tighter labour markets in the US1, which leads to an increase in wages. As wages increase, US corporates pass higher costs through, and so the Consumer Price Index (CPI) picks up.
This doesn’t happen in Europe to the same extent. For most countries in Europe, two-thirds of labour is set by collective wage agreements (including unions). Collective bargaining happens annually to cover the cost-of-living increases and therefore lags inflation. This means that collective wage agreements are pro-cyclical, and as wages lag inflationary pressures, they don’t lead them.
Figure 2. Proportion of employees covered by collective bargaining arrangements
Compared to the US and the UK, there’s little sign of European wage pressure and the inflation debate therefore remains ‘transitory’. The ECB remains strongly accommodative, even though some of the emergency measures – such as the pandemic emergency purchase programme (PEPP) – are being scaled back. QE will mainly continue through the asset purchase programme scheme (APP), which is set to reduce gradually through 2022. Meanwhile, ECB President Lagarde is sticking to the ‘no rate rise’ rhetoric.
We doubt this is sustainable. The current consensus is that there’s no wage inflation in the EU, but we believe it’s the biggest ‘risk’ to equity market positioning. Figure 3 shows that the European unemployment rate is back to recent lows (7.2%). The last time unemployment fell below 7% was back in the 1980s. At the same time, there are some early signs of genuine labour tightness (Figure 4).
Figure 3. Euro area unemployment rate
Figure 4: Labour shortages in industry versus labour shortages in services
Unlike in the US and the UK, there’s a scarcity of good data for European income trends, leaving us reliant on bottom-up data to forecast wage pressure. Data capturing the activity of temp workers can be useful, with European temping companies confirming that the hours worked by temps are continuing to increase, while demand for new temps is improving. Figure 5 shows French temping volume finally turning positive in December. We also hear of improving white collar wage data and an increasing quit rate.