Carmignac: From one cut per quarter to one per meeting

16 oktober 2024

The European Central Bank (ECB) has been living in both hope and fear. Hope that growth would finally pick up after five consecutive quarters of GDP hovering around 0%, and fear that persistent inflation - in wages, notably - would limit the pace of disinflation.

The opposite has happened.

Leading indicators (PMI's) have surprised on the downside, particularly in Germany and the manufacturing sector. This paints a pessimistic picture and makes the prospect of a rebound in economic growth questionable.

Inflation has also surprised on the downside, with year-on-year consumer prices finally falling below 2% in the region's four main economies. The most volatile components - energy and food - are certainly contributing to this, so is underlying inflation. And, with the exception of Italy and Spain, hiring intentions are trending lower. It seems likely that underlying inflation data publications are below the ECB’s projections.

Nevertheless, seasonal and one-off factors (the Olympics in France, notably) mean these publications can be taken with a pinch of salt. One-off figures do not make a trend! But Lagarde’s data dependency implies that monetary policy is likely to change and, hence, that the pace in interest rates cuts is likely to accelerate.

We expect another 0.25% interest rate cut at this week meeting. Of course, the ECB is likely to maintain its messaging of a ‘pragmatic and gradual’ approach. The guidance is that monetary policy decisions are being conducted on a meeting-by-meeting basis, dependent on the evolution of growth and inflation. However, bond markets are looking further ahead and are already anticipating one rate cut per ECB meeting until April 2025. The market expects the deposit facility to ’land’ at 2% during the summer of 2025.

Such an expectation seems fair given the current environment. But what happens next, as always, is open to debate.

If fixed income markets expect neutral rates to be between 2% and 2.25% for the foreseeable future, those same markets are ‘telling’ us that inflation in the eurozone should hover around 1.75% over that same time horizon. In other words, real rates (i.e. nominal interest rates minus the inflation rate) will evolve from 0.4% and 0.5%.

This is a questionable assumption. It implies the ECB will struggle to implement accommodative policy (if  proved necessary) and ignores European structural issues, the estimated fiscal brake is at -0.5% of GDP in 2025, and Chinese stimulus intentions that favour domestic growth.  

Investment implications

On the other side of the Atlantic, concerns are that monetary policy has gone “too far, too fast”. On this side, worries are that the ECB has done “too little, too late”.

As a result, European core bonds, on the whole, appear more attractive than their US counterparts.

Among the former, we believe 2- to 5-year maturities are offering the most value, as they are the most likely to reflect a potential accommodative monetary policy bias, especially in real terms.

Such instruments complement a credit tilt in portfolios, given the healthy yields on offer – comprised between 4.5% and 6.5%. This means credit remains a predictable driver of performance in a world where uncertainty is, alas, still the order of the day.