All eyes were once again on interest rates last week, as the European Central Bank (ECB)—the eurozone’s equivalent of the Federal Reserve Board–raised interest rates by 75 basis points. Notably, it was the largest single rate hike in the ECB’s history, and it took the deposit rate above 0% for the first time since 2012.
Eurozone inflation is rising rapidly due to soaring energy prices caused by the Russia-Ukraine war and ongoing supply chain challenges. Sounding much like U.S. Fed Chairman Powell, ECB President Lagarde teed up more rate hikes down the road and emphasized the importance of frontloading the move to higher rates with the aggressive increase. ECB watchers are increasingly speculating that another 75 basis point increase could occur at the council’s October meeting.
At Horizon, we have underweighted Europe in our portfolios for some time. For example, our core allocations have not held direct positions in European equities for close to six months. Although relatively low valuations in European stocks may look appealing on the surface to some, a deeper analysis reveals weakness that justifies those valuations:
- The ECB revised its inflation expectations upward to an average of 8.1% this year.
- Surging oil and gas prices are creating a significant deterioration in Europe’s terms of trade–the ratio of its import prices to its export prices–that could be as bad as (or worse than) what Europe saw in the 1970s.
- Many European countries are proposing windfall profit taxes on energy companies and banks–two sectors representing a significant percentage of European stock market indices.
- Europe’s largest trading partner–China–continues to experience ongoing economic weakness.
The upshot: At the moment, European securities are cheap for good reasons–and, therefore, not a compelling investment opportunity in our view. Given the worsening outlook for the Continent, we are maintaining our overweight position to the U.S. market in our portfolios for the time being. We will continue to monitor underlying fundamentals and geopolitical developments.
This commentary is written by Horizon Investments’ asset management team.
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