Europe: Economic and Market Outlook

As we look towards 2023, it is clear that the year will bring a shift in monetary policy dynamics and market focus. Central banks, including the Federal Reserve, the European Central Bank, and the Bank of England, are expected to transition from aggressive rate hikes to a more moderated stance. The narrative around rate hikes will likely give way to discussions of a pause, with actual rate cuts remaining a 2024 story. Inflation is expected to decline but stay significantly above central bank targets, maintaining a challenging economic and investment environment.

Central Bank Dynamics: A Year of Balance

The Fed is widely expected to slow its pace of rate hikes to 50 basis points in December 2022. This moderation reflects its acknowledgment of prior tightening's impact while maintaining a firm stance on controlling inflation. Terminal rates are likely to reach 5.00%-5.25%, with the Fed keeping rates in restrictive territory throughout 2023. This policy stance will likely weigh on the US economy, leading to a deeper recession in the second half of the year, potentially followed by more significant rate cuts in 2024.

The ECB faces a dual mandate, balancing inflation control with concerns about market fragmentation. With rates projected to exceed the neutral 2% mark, the ECB will have to navigate rising borrowing costs across its member states. A more balanced approach to monetary policy is expected, shaped by inflation trends and efforts to prevent economic divergence within the eurozone.

The BoE, like the ECB, will likely reduce the pace of its hikes, maintaining vigilance over inflation while managing the economic fallout from tighter financial conditions and elevated energy costs.

Europe’s Economic Landscape: Recessionary Challenges

Europe entered a recession in late 2022, with sluggish growth projected to persist through mid-2023. The eurozone's economic challenges stem from high energy costs, geopolitical tensions, and structural vulnerabilities exacerbated by the Russia-Ukraine war. While efforts to diversify energy sources and reduce reliance on Russian supplies are underway, recovery will depend on global macroeconomic trends and regional resilience.

In contrast, the US economy is likely to remain robust in the first half of 2023, supported by a strong labor market and resilient consumer spending. However, the Fed’s restrictive monetary policy will likely trigger a more pronounced downturn in the latter half of the year.

Equities: A Case for European Outperformance

In early 2023, equity markets are expected to experience favorable conditions, supported by easing rate volatility and investor positioning. Europe, in particular, could outperform the US due to several factors:

• Energy Price Relief: Europe's proactive efforts to secure alternative energy sources are expected to alleviate some of the economic pressures caused by high energy costs.

• China Reopening: A rebound in Chinese economic activity would disproportionately benefit Europe, given its deeper trade ties with China.

• Relative Policy Stance: While the Fed is expected to keep rates in restrictive territory, the ECB may adopt a more balanced approach, limiting downside risks for European equities.

Investors' underweight positioning in Europe, driven by growth concerns and geopolitical risks, presents an opportunity for a relative rebound. Within equities, sectors such as financials, value, and quality are likely to outperform as recession risks become more apparent. Conversely, technology and growth-oriented sectors may face headwinds from rising rates and tighter financial conditions.

Rates and Fixed Income: A Positive Outlook

The rates market is set for a positive year in 2023 as yields are unlikely to revisit the highs of late 2022. Recession concerns and expectations of eventual central bank rate cuts should drive rates lower, providing a supportive environment for fixed-income investors.

Yield curves, which have been unusually flat due to aggressive monetary tightening, are expected to steepen structurally as inflation eases and rate hikes slow. This steepening trend could emerge as early as Q1 2023, driven by reduced policy uncertainty and stabilizing inflation expectations.

In the European bond market, net issuance is expected to rise sharply, particularly in peripheral economies like Italy, where higher funding needs and the ECB's shift from quantitative easing to quantitative tightening will amplify supply pressures. Italian spreads appear tight given these dynamics, making them vulnerable to widening in the face of slowing growth and increased issuance.

Geopolitical and Structural Drivers

The trajectory of European markets in 2023 will also depend heavily on geopolitical developments, particularly the ongoing Russia-Ukraine conflict. While a resolution remains uncertain, progress in negotiations could provide a significant boost to sentiment, particularly in energy markets. Conversely, prolonged instability would exacerbate economic challenges, especially in energy-dependent industries.

China’s reopening and global supply chain normalization are additional wildcard factors that could influence European growth. A faster-than-expected recovery in Chinese demand would benefit European exporters, offsetting some domestic economic weaknesses.

Positioning for 2023

The first half of 2023 offers opportunities in equities, credit, and rates, driven by favorable macro trends and investor positioning. Credit markets, in particular, are well-positioned to outperform equities in an environment of stable or declining rates. The higher yield environment should also attract institutional inflows into fixed income.

For investors, a strategic tilt toward Europe, with a focus on value and quality sectors, appears prudent. Maintaining flexibility to adapt to evolving macro conditions and geopolitical risks will be essential for navigating the year ahead.

As 2023 unfolds, market participants should prepare for a dynamic landscape shaped by policy shifts, economic challenges, and global uncertainties, with Europe poised to emerge as a relative outperformer in the near term.

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