How Eurozone Inflation and ECB Policy Could Impact Markets
- With eurozone inflation at elevated levels and recession risks lurking, jittery European financial markets seem to be driven by monetary policy and how the bloc's economy will evolve.
- The outlook for markets depends crucially on the severity of the supply-driven economic shock, how decisively the European Central Bank responds and whether it maintains credibility in managing inflation.
- In our "Stagflation" scenario, which assumes high inflation, sluggish growth and a monetary-policy response that markets consider insufficient, a portfolio of European equities, bonds and real estate could lose around 10%.
The eurozone is battling on multiple fronts
Following the ECB's announcement of monetary-policy normalization1 after inflation hit a record 8.1% for this year until the end of May, the German two-year and 10-year interest rates increased steeply. The spread between the 10-year Italian and German government-bond yields also rose to levels last seen during the pandemic over fears of "fragmentation risk," but have come down after the ECB's ad-hoc meeting.2 Faced with diverging sovereign borrowing costs and weaker job market and household consumption than in the U.S.,3 the ECB might have less leeway than other central banks in its battle against inflation.
European sovereign-bond yields since January 2020
For market-illustrative purposes, during this period only.
Four scenarios for eurozone inflation and ECB policy
With high uncertainty around food and energy prices and their impact on inflation and growth in Europe, it is important to consider a wide range of possible economic and financial scenarios in order to gauge potential risk to investment portfolios. We consider the impact of the following four scenarios on portfolios of European stocks, bonds and real estate: 4
- Soft landing: Further upward pressure on energy and food prices is avoided, allowing inflation to subside. At the same time, European economic growth is strong, supported in part by EU recovery funds. Equities gain, nominal rates and inflation expectations subside, and the euro regains some lost territory against the dollar.
- Sustained inflationary pressure: Energy and food prices remain elevated and input/producer costs trickle more and more into output costs, paving the way for a sustained inflationary environment. At the same time, the ECB's credibility slightly deteriorates as it is reluctant to decisively hike rates in the short term, amid fears of slowing growth and fragmentation risks. Equities decline, inflation expectations and long-term rates jump up and the euro weakens further against the dollar.
- Slowing growth: The ECB tightens decisively, causing a slowdown in economic growth in the eurozone and putting upward pressure on peripheral European sovereign yields. The swift action and credibility of the central bank allow inflation to subside, but at an economic cost. Equities fall, nominal rates increase and inflation expectations subside.
- Stagflation: The ECB starts to increase rates but inflationary pressures are so high that the hikes are deemed insufficient, leading to a significant loss of the central bank's credibility. As consumers and corporations revise their long-term inflation expectations upward, expectations for long-term economic growth take a hit. Equities drop significantly, nominal rates and inflation expectations surge and the euro loses against the dollar.
What we assume in our scenarios
None | Soft landing | Soft landing | Sustained inflationary pressure | Sustained inflationary pressure | Slowing growth | Slowing growth | Stagflation | Stagflation |
Inflation | EUR BEI 2Y: -90bps | EUR BEI 10Y: -40bps | EUR BEI 2Y: +90bps | EUR BEI 10Y: +50bps | EUR BEI 2Y: -90bps | EUR BEI 10Y: -30bps | EUR BEI 2Y: +120bps | EUR BEI 10Y: +40bps |
Nominal Yields | German Govt 2Y: -70bps | German Govt 10Y: -30bps | German Govt 2Y: -20bps | German Govt 10Y: +60bps | German Govt 2Y: +90bps | German Govt 10Y: -20bps | German Govt 2Y: +80bps | German Govt 10Y: +80bps |
Equity | MSCI Europe +14% | MSCI Europe +14% | MSCI Europe -3% | MSCI Europe -3% | MSCI Europe -4% | MSCI Europe -4% | MSCI Europe -15% | MSCI Europe -15% |
Credit spreads | EUR IG: -25bps | EUR HY: -80bps | EUR IG: +15bps | EUR HY: +60bps | EUR IG: +10bps | EUR HY: +40bps | EUR IG: +30bps | EUR HY: +120bps |
EUR/USD | +7.5% | +7.5% | -5% | -5% | - | - | -5% | -5% |
Scenario assumptions are informed by the MSCI Macro-Finance Model, with a combination of hypothetical macroeconomic shocks and monetary-policy responses. The scenarios differ in their assumptions of the underlying macroeconomic shocks and central-bank policy strength and credibility with the public. We use breakeven inflation (BEI) for market-implied expectations for inflation. These are not forecasts, but hypothetical narratives of how the various inflation scenarios could affect global multi-asset-class portfolios.
Potential implications for financial portfolios
To assess the scenarios' impact on multi-asset-class portfolios, we used MSCI's predictive stress-testing framework and applied it to a hypothetical global diversified portfolio.5 The exhibit below shows how 10-year sovereign spreads over the German bund's yield were impacted under our scenarios. We see that under the "Slowing growth" and "Stagflation" scenarios, in both of which the ECB tightens more aggressively, peripheral sovereign spreads are impacted more severely.
European sovereign-spread moves, as implied by our scenarios
None | Soft landing | Soft landing | Sustained inflationary pressure | Sustained inflationary pressure | Slowing growth | Slowing growth | Stagflation | Stagflation |
Italy | -35 | -35 | +10 | +10 | +30 | +30 | +45 | +45 |
France | -10 | -10 | +5 | +5 | +5 | +5 | +10 | +10 |
Spain | -20 | -20 | - | - | +20 | +20 | +20 | +20 |
Greece | -40 | -40 | - | - | +35 | +35 | +50 | +50 |
In basis points. Based on market data and factor correlations as of June 10, 2022.
For a diversified portfolio consisting of European equities, bonds and real estate, the impact ranged from a 10% loss in the "Stagflation" scenario to an 8% gain in the "Soft landing" scenarios. The "Sustained inflationary pressure" and "Slowing growth" scenarios registered comparable losses, of 2% to 3%. The exhibit below shows more detailed results, by asset class and region and for various base currencies.
Impact across asset classes under our scenarios
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Portfolio impact of the scenarios based on market data as of June 10, 2022. Sovereign bonds are represented by Markit iBoxx indexes. Equity markets and corporate bonds are represented by MSCI indexes. Private equity and Japanese corporate and sovereign bonds are represented by model portfolios. European real estate is represented by the MSCI Pan-European Quarterly Property Fund Index. The composite Europe portfolio is represented by the following weights: 50% European equities (35% public and 15% private), 20% European sovereign bonds, 10% European investment-grade bonds, 10% European high-yield bonds and 10% European real estate. Source: S & P Global Market Intelligence, MSCI
The ECB's move
All eyes are on the ECB and other central banks and how they will react to rampant inflation. In the eurozone, where a weakening growth outlook and diverging sovereign borrowing costs complicate the picture, cautious investors can prepare by assessing a range of potential outcomes.
Further Reading
1 “Monetary policy decisions.” European Central Bank, June 9, 2022.2 “Statement after the ad hoc meeting of the ECB Governing Council.” European Central Bank, June 15, 2022.3 Armstrong, Robert, and Wu, Ethan. “Why Europe’s inflation is different.” Financial Times, June 1, 2022.4 The shocks in these scenarios are not meant to be instantaneous, but rather on a horizon of roughly six months, as changes in the market will take time to materialize.5 The results are generated based on this methodology, using MSCI's BarraOne®, whereby we used current correlations to propagate the shocks to a hypothetical multi-asset-class portfolio. MSCI clients can access BarraOne® and RiskMetrics® RiskManager® files for these scenarios on the client-support site.
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