Written by Nicola Mai, Economist, Sovereign Credit Analyst at PIMCO
Despite a resilient early start in 2023, the eurozone economy was weak through much of the year, and we anticipate that this fragility will persist in 2024.
After hitting a high of around 54 in April 2023, the eurozone Composite Purchasing Managers’ Index fell below 50 in June and has remained there since, indicating an economy in mild contraction. Our forecast is for a period of stagnation or a mild contraction in the eurozone this year (for more on our global economic outlook, see our latest Cyclical Outlook, “Navigating the Descent”).
The reasons for this ongoing weakness are clear. Europe is still recovering from a lingering energy shock and has not experienced the same degree of fiscal stimulus as the more resilient U.S. economy in recent years. The region’s shorter debt maturities also mean that interest rate hikes have been felt more quickly.
Europe’s challenges have been exacerbated by an underperforming Germany, which has been a drag on regional growth. German industrial production experienced its sixth consecutive monthly decline in November, contracting by 0.7% month-over-month against consensus expectations of a 0.3% increase. This aligns with recent declines in German industrial orders, underscoring persistent fragility within the German manufacturing sector.
While softness in Germany partly mirrors weakness in the global industrial cycle, structural headwinds – such as a loss of competitiveness vis-à-vis China and higher gas prices since the onset of the Ukraine war – are also likely playing a role. There is also little hope that fiscal policy will come to the rescue, given recent constitutional court decisions. Granted, there are some signs we are past the peak in terms of weakness, but there is little evidence to suggest German industry is turning a corner in a decisive way, and the overarching picture is of an economy struggling to gain momentum. Given that Germany accounts for over a quarter of eurozone GDP, its impact on the wider region is significant.
As for potential shocks in 2024, we do not expect the current shipping turmoil in the Red Sea to have a major impact on inflation in Europe, as it stands. Its scale is a fraction of the pandemic-related disruption, and shipping itself is only a small component of the cost structure of a company. Global goods demand is not as buoyant as it was during the pandemic, and the supply of new container ships looks set to be ample this year. Importantly, there are other supply routes available to companies, including alternative sea routes and air freight. That said, COVID-19 taught us to be wary of ripple effects on the supply chain.
Inflation and rates outlook
Inflation has peaked in Europe and is now falling rapidly, with headline inflation already below 3% in the eurozone and core inflation slowing to around 3.5% year-over-year. At higher-frequency measures, inflation has fallen even lower – Figure 1 shows that on a three-month annualised basis, core inflation is below the European Central Bank’s 2% target.
Figure 1: Eurozone core inflation
We believe the European Central Bank has finished its round of tightening and will look to cut rates this year. We see the ECB proceeding with caution initially, given that the central bank will want to feel certain it has won the fight against inflation (and it may want to see signs of wage disinflation first), but from our perspective, rates are on the way down.
The ECB, like other developed market central banks, is wary of monetary policy mistakes that would allow inflation to reaccelerate – a problem now synonymous with former Federal Reserve Chair Arthur Burns, whose dovish policy stance in the 1970s contributed to an unwelcome phase of reflation in the U.S. economy. Given this, the ECB may end up cutting the policy rate by less than what the market currently is pricing for this year. Beyond that, however, we see potential for deeper cuts versus what is priced, given our view that equilibrium interest rates in Europe and globally remain low.
What does this macro outlook mean for European bond markets? We are cautious on the front end of the curve but we do see opportunities in the intermediate part, with our forecast for deeper rate cuts over time alongside our view that destination policy rates remain low. Being in this part of the curve also avoids the long-end which may be susceptible to elevated issuance needs and the ECB reducing its balance sheet. We consider European duration to be an effective portfolio diversifier: Although yields are generally lower compared with the U.S., the relatively subdued macroeconomic outlook for the region should allow European fixed income markets to perform.
Importantly, duration interest rate risk has hedging properties, so if we experience a deeper downturn than anticipated, fixed income duration should perform. Also, while cash has been king for many investors, cash yields are fleeting and are unlikely to be as high tomorrow as they are today. Locking in higher yields by having some duration exposure in portfolios makes sense, in our view.
