Alternative Investment Report

European economy grows, but that could be a bad thing…

It’s a curious time when good news can’t be celebrated because, well, good news is bad news.

That is the unusual scenario the market has faced in recent months, however. As inflation has surged, central banks are keeping their eyes trained on the economic news to diagnose signs of a slowdown. In order to get on top of the rampant rises in the cost of living, there must be at least some slowdown in demand, or so the theory goes.

This is why stocks have traded with a funny relationship vs economic data in recent months. Good employment numbers can be too good, meaning higher rates are not having the desired impact on the market. This in turn can increase the likelihood of more rate hikes in the future, which as we all know by now, is the death sentence for stocks.

And so we have all been playing this funny game of waiting for important data releases – CPI figures, job numbers, industrial figures, and whatever else comes across the desk. And then the all-important exercise of guessing how central bankers will react comes next.

Markets have risen in 2023

Thus far this year, the market has been more optimistic.

Interestingly, in this big game of poker that we call the stock market in 2023, this has been a case of investors calling central banks’ bluff.

Policymakers have been adamant that rates will continue to rise, yet investors have chosen to believe that the more positive inflation data and greater threat of a looming recession will force them to change their minds.

After all, inflation expectations encourage more inflation through a sort of self-fulfilling prophecy, part of the reason why the market thinks Jerome Powell and co. are bluffing. Powell has scoffed at the positive market moves, making no secret of his displeasure.

The historical record cautions strongly against prematurely loosening policy. We will stay the course, until the job is done

Jerome Powell in December

Eurozone activity grows

But back to good news is bad news. Today, a survey revealed that the eurozone has returned to positive growth for the first time since last June. The stronger numbers than expected came in the purchasing managers’ index, which measures activity in manufacturing and services. This was wholly unexpected, and now investors fear that this may encourage the ECB to kick up rates faster, which have risen at the fastest rate since the eurozone bloc was established.

ECB President Christine Lagarde toed a very hawkish line before Christmas:

We’re not pivoting, we’re not wavering, we are showing determination.

Christine Lagarde

The ECB has been significantly slower than the US with regard to raising rates. This is partially due to the downfalls of having a single monetary union but multiple different fiscal approaches between countries.

Debt-laden countries such as Italy get hit harder by rising rates, as the interest payments on their debt become more burdensome, which is not a good problem when the continent is already on the brink of recession. Yet on the flip side, more fiscally disciplined nations like Germany want higher rates to rein in inflation.   

This article by my colleague Shivam Kaushik is a nice in-depth look at the dynamics. The divergence between the bond yields of Germany and Italy is a good way to measure this, and indeed the health of the whole eurozone. While the below chart shows that the spread has come down since the times of max concern last summer, it remains at 1.8%, after being near zero in 2021.

What happens next?

For now, the market is treading along with cautious optimism that with inflation softening, there could be light at the end of the tunnel. The other issue is then whether this light is only achievable after trudging through a recession, and if so, how bad will it be?

Talk of a soft landing remains alive, although concern remains that there could be unemployment spikes, large falls in demand and that the monetary tightening cycle has gone too far, with a painful recession now inevitable.

The next key date is February 1st when the Fed will announce its latest interest rate policy. And all over again, the markets will play their game of cat and mouse. Isn’t it fun?

The post European economy grows, but that could be a bad thing… appeared first on Invezz.