ECB set to raise interest rates as stagflation beckons

With inflation at 8.1% and economic growth at just 0.3%, the eurozone is on the brink of stagflation. To combat it the European Central Bank is to stop buying bonds immediately and could raise interest rates next month.

euro sculpture outside the ECB in Frankfurt
The European Central Bank is to stop buying bonds
(Image credit: © ANDRE PAIN/AFP via Getty Images)

“The eurozone is on the brink of stagflation,” says Eric Albert in Le Monde. Annual inflation hit 8.1% last month, a level unprecedented since the creation of the single currency. Energy prices, which rose at an annual rate of 39% in the past year, were the main cause, but “gradually the phenomenon is spreading to the entire economy”. At the same time, growth was just 0.3% in the first quarter. Industry is holding up reasonably well for now, but households are being “strangled by the sudden rise in the cost of living”.

Few economists “expect an outright recession” in the year ahead, says The Economist. “Many services firms are still reaping the rewards from reopening,” especially in the euro area’s tourism-reliant south. A cushion of pandemic savings and “plentiful” jobs should provide a backstop for consumer confidence. Yet the European Central Bank (ECB) finds itself in the tricky position of balancing soaring energy prices and a weaker growth outlook. In America loose government spending has contributed to rocketing inflation, but Europe’s price rises come mainly from the supply side, which a central bank can do little to control.

This week the ECB was poised to announce that it will stop buying bonds imminently. That should pave the way for interest-rate rises next month, say Dhara Ranasinghe, Tommy Wilkes and Saikat Chatterjee for Reuters. The bank’s deposit rate is currently at -0.5% and hasn’t been raised since 2011. There is growing speculation that policymakers might even opt for a 50-basis point rise (rather than the expected 25-point rise) to get inflation under control.

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Earnings can’t beat the gloom

The pan-European Stoxx 600 index is down more than 9% since the start of the year. Even so, corporate earnings have been robust, says Ian Johnston in the Financial Times. “Earnings per share grew by 42% for the 452 companies in Europe’s Stoxx 600 share index that reported first-quarter numbers,” compared with 9% for US stocks. About half of European blue-chip earnings come from outside Europe, so the weak euro is also juicing earnings.

Strong earnings have been powered by the commodity-price boom, says Société Générale. Commodity-linked sectors account “for close to 10% of the market capitalisation in Europe, but almost 20% of total earnings”. As of the end of April, the Stoxx 600 was trading at a forward price/earnings (p/e) ratio of 13.1, below historical averages. Yet that discount comes from historically low valuations for commodity firms. “Looking at the Stoxx 600 excluding commodity-linked sectors… the forward p/e is at 14.5 times, so still above the ten-year and 20-year historical averages.”

Still, on a long view, it might pay to look at Europe’s smaller stocks, says Ollie Beckett of Janus Henderson. European small caps returned 301% in the decade to the end of 2021, compared with 194% for large firms. “The European economy has been criticised for being sluggish, but the universe of smaller companies continues to produce dynamic and innovative businesses that are well-placed to benefit from… factors such as the energy transition, or the changing healthcare landscape.”