European inflation – Pointing down

The first week of 2023 will see the release of December CPI inflation across Europe.

Energy and electricity prices continued to stabilize in December, suggesting some downside to the c.10% print registered in November. In Spain, the CPI was released early (last Friday), coming in at 5.8% yoy, 1% lower than November’s number. In Germany, December saw the beginning of energy support to households, which may contribute to a softer inflation print. Consensus sees German CPI at 10% for December, 1% below the reading in November. December may be the first month in which there is a proper drop in European inflation, following some stabilization in October and November. Our internal model sees EZ inflation close to 7% by summer.

Even so, core price pressures will remain elevated. Second order effects are stickier as it takes time for energy disinflation to feed through to the core data. In Spain, core prices accelerated 60bp to 6.9% yoy in December (although some calculation differences vs Europe bias / positively impact the number). Additionally, the ECB has just revised inflation higher for 2023, stressing the importance of core inflation. Higher core inflation and a more hawkish ECB means the space for Eurozone rates to ease meaningfully as a result of lower headline inflation is limited. We continue to think Eurozone rates are more fragile than US rates, and see potential upside in Q1, particularly in bunds and OATs.

China – Re-opening wave

China is experiencing a new massive Covid wave, after taking steps to re-open the economy in mid-October. Following two years of single-digit daily cases across the country, recent reports suggest daily infections are now in the millions.

The outbreak may slow down the re-opening process across the country as intermittent lockdowns may be necessary and disruptions in labor supply will be widespread. Still, the country has switched quickly from a target of almost zero cases per day to the tolerance of millions daily cases per day. This can be read as a higher commitment to re-opening the economy with positive medium-term consequences on economic growth.

With the US and Europe set to grow close to 0% in 2023, a mean-reversion of China towards 4-5% growth rates would mean the growth gap with the western world goes back to 7-year highs. Traditionally, this gap is a tailwind for non-US assets, in particular Asia. With Europe and emerging markets being structural underweights in investors’ portfolios, and with the US dollar at its 30 year high in real terms, non-US assets may benefit strongly if this trend continues to get validation in Q1 2023.

Algebris Investments’ Global Credit Team