European stocks 20% off lows, but banking turmoil & global recession fears loom

Europe has had a rough year. But it’s getting better, if only cautiously. 

The Stoxx 600 Index, which covers 90% of the market capitalisation of the European stock market, is nearly 20% off its lows last September. It is now only 6% off the mark it opened 2022 at, more or less the market peak. 

2022 brought ugly losses for investors as the region was hit on multiple fronts. Russia invaded Ukraine in February 2022, sparking an energy crisis and exacerbating an already-brewing inflation spiral. 

The ECB transitioned to a tight monetary policy, forced to raise rates to reign inflation in. Of course, this sucked liquidity out of the economy and prices cratered as a result, the Stoxx 600 shedding 22% of value in the first nine months of the year. 

Inflation softens and European stocks rise

But after nine months of pain, markets began to pick up in Q4 of 2022. Not by coincidence, this coincided with inflation peaking and optimism that the hiking cycle may not persist for as long as previously expected. 

Eurozone inflation peaked at 10.6% in October and has been coming down since.  

However, the recent quarter has thrown a bit of a spanner in the works. Interest rate rises may attack inflation, but it doesn’t come without cost. This is economic theory 101, and the world knew it was a possibility. 

That possibility became a reality last month, as things started breaking. Specifically the banking sector, which wobbled after Silicon Valley Bank collapsed in the US. The contagion was imported across the Atlantic via Credit Suisse, which was forced into a shotgun marriage with fellow Swiss bank UBS.  

“Central banks are caught between a rock and a hard place”, said Morningstar analysts in their report for the Europe Equity Market Outlook in Q2 2023.

“Recent data in the United Kingdom (shows) inflation is on the rise again, forcing central banks to accept a certain level of collateral damage in the form of business failures, to achieve the goal of bringing inflation under control.” 

This was demonstrated by the European Central Bank’s 50-basis-point rise on March 16”, they added. 

It sums up the issue facing central banks currently. In truth, it has once they have faced all year: toeing that line between hiking rates enough to curtail inflation, but not so much that a recession is triggered. 

The coveted “soft landing” remains the goal, but with inflation as high as it has been since the 1970s, that is a big challenge. And for those bullish that the inflation beast has been slain, let us not forget that in the US in the 70s, inflation came down three times before spiking up even higher – a tale of caution for policymakers and investors alike. 

What happens next for the stock market in Europe?

Yet while the 70s presents as an interesting comparison, the world is a different place today than it was 50 years ago. 

Back then, US President Richard Nixon abandoned the gold standard, sparking the rampant inflation which resulted in interest rates rising to close to 20% (!). That is a far cry from the 5% rates which the US is currently hanging around (and Europe is much further behind). 

Then there is also the fact that the world is emerging from a pandemic which locked down economies like never before. It really is an unprecedented macroeconomic environment. 

We’re at a strange point in the market cycle where conditions are far from perfect, persistent inflation, rising interest rates, and cash-strapped consumers, all of which requires investors to really look beyond the short term and have faith that the economy will be better in 6-9 months time

Michael Field, European Equity Strategist, Morningstar

The above quote from Field sums up the predicament. Markets have risen over the past six months on the faith off the back of this confidence that the economy will indeed be better in 6-9 months time. But whether this persists going forward remains to be seen. 

“The problem with this situation is the confidence required to keep markets going is precarious, and incidents like those occurring in the banking sector in March are enough to tip the scales towards pessimism”, Field adds. 

That is the fear. But with the world seemingly collapsing all around us, markets have been able to stay (reasonably) afloat until now. The trillion dollar question is whether that can continue…