Opportunities remain, but on a selective basis

The major European economies may grow significantly faster, in the 4.0% to 5.0% range in 2022, above the long-term average, driven by the release of pent-up demand, improving consumer sentiment, booming industrial activity, and fiscal support. Services and manufacturing are leading the recovery, with construction lagging due to an acute shortage of labour and raw materials.

The Omicron variant remains a key risk and could slow the recovery in the first half of 2022; however, hospitalisations and deaths have remained relatively contained compared to the peak of the pandemic, making governments reluctant to reimpose lockdowns.

Inflation could prove more persistent in 2022 given strong demand and continuing supply problems. Core inflation in the eurozone rose above 2% for the first time in almost 20 years (chart 1), while high energy prices and persistent supply bottlenecks could mean inflation only falls slowly towards 2%. Structurally looser fiscal policy and accommodative monetary policy may also boost inflation. Companies are facing higher input costs and expect to increase selling prices to defend margins. Eurozone wage growth remains subdued but, with increasing evidence of labour shortages (chart 2) and rising employment, it could increase more rapidly.

The European Central Bank (ECB) turned marginally more hawkish in December. It announced the termination of its Pandemic Emergency Purchase Programme (PEPP) and upgraded its inflation projection to 1.8% in 2023, back to the pre-pandemic level (2018), acknowledging the upside risk to inflation. However, the ECB remains relatively accommodative compared to other central banks; it does not expect to raise interest rates in 2022 and its Asset Purchase Programme (APP) is open-ended.

Opportunities remain in the European complex, on a selective basis. We are underweight duration in European government bonds, through countries such as France and Italy due to less technical support from the ECB. The termination of the PEPP would likely be negative for peripheral spreads, we believe. Political uncertainty in France and Italy also remains high given electoral risks. We continue to see opportunities in Danish covered bonds, which provide attractive valuations and strong fundamentals.