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Following the sharp rise in the price of energy in the aftermath of Russia’s invasion of Ukraine, the market has since been expecting the eurozone economy to enter a recession in view of the high inflation and the consequent erosion in real household income and corporate profitability. This has not materialised as yet, given that growth was supported by rebounding services consumption and catch-up growth in industry that had been constrained by supply bottlenecks.
Energy prices have moderated significantly over the past few months and the year-on-year comparisons will thus become easier. However, a recession still looks the most likely scenario in the eurozone. This is because the factors that have driven growth so far this year have largely vanished. Moreover, financial conditions have tightened significantly due to the aggressive interest rate hikes by the European Central Bank (ECB), with further increases on the cards. However, moderating energy prices may mean that the recession is actually shorter and shallower than it might otherwise have been.
Just as the expected recession has not arrived yet, neither has the anticipated sharp downgrade to corporate earnings. More moderate energy prices would be a boon for corporate profit margins as is the ongoing unwinding of the supply chain disruptions caused by the pandemic. Both factors could help earnings to remain resilient, even as additional cost pressures may come in the form of higher wage demands.
Nonetheless, it is undoubtedly true that the economic backdrop will be difficult in 2023. Even if inflation moderates from its current levels of around 10 per cent, it is unlikely to fall back to the ECB target level of 2 per cent. In effect, the ECB is still on course to begin quantitative tightening next year, a process in which it will seek to shrink the size of its balance sheet by replacing fewer maturing bonds. What this means in practice is tighter liquidity in financial markets, which is generally not a good thing for equities. Moreover, we also have to consider that higher interest rates mean higher financing costs for governments, corporates and individuals. As a result, consumption and investment are likely to be hit.
If Europe does enter a recession, downgrades to corporate earnings are likely to ensue. Those companies and sectors that can potentially provide some earnings stability will therefore be a key focus for investors in the coming twelve months.
Banks are a sector that could do well. Many eurozone banks are still looking attractively valued and higher interest rates are positive for the repricing of loans. Clearly, a recession would cause a rise in provisions and bad debts, but if the recession is short and/or shallow, then the negative impact would be more limited than some might fear. Economically-sensitive sectors such as industrials or technology could also fare relatively well, especially if any recession proves to be short-lived.
Meanwhile, an area that has particularly suffered in 2022 but which could see some form of reversal next year is small and mid-sized companies. In general, a more favourable sentiment towards equities tends to result in outperformance for small cap shares compared to large caps.
At this stage, it is still possible that the worst case scenario of a steep and prolonged recession can be avoided. This would support better sentiment towards eurozone equities, particularly as the region remains extremely out of favour with investors. Of course, the elephant in the room remains the war in Ukraine. Given that and the uncertainties around the growth outlook, it may be opportune not to take an aggressive positioning in the market as yet.
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