The Russo-Ukrainian conflict to change ECB plans

By Gergely Majoros, member of the Investment Committee at Carmignac

• ECB likely to keep maximum flexibility and options for the coming months
• Investors to be prepared for more “symmetrical” central banks’ decisions

The current economic backdrop puts the European Central Bank (ECB) in a particularly tricky position to define an optimal monetary policy. Will the ECB be in a position to decide to not to fight the anticipated inflation dynamics? It is very difficult to predict.

From a purely economic standpoint, the Russian invasion of Ukraine already represents a “stagflationary” choc to the European economy. If the current crisis lasts for a long period of time or worsens further, it will inflate energy and food commodities prices further which will significantly increase the odds of a recession in Europe.

With this outlook, the ECB isn’t likely to confirm its recent ‘hawkish’ shift at its next meeting. While the probability that the ECB would accelerate its taper and set the path for interest rate hikes going forward was high before the Russian attack, this is now unlikely. On the contrary, it could further support fiscal policies in Europe, keep maximum optionality for the coming months, without totally capitulating on its ‘hawkish’ shift instigated in January.

In this respect, one possible option for the ECB would be to sacrifice the announced “sequencing” of its normalisation measures, which foresees to end quantitative easing (QE) before hiking rates. This does not seem very likely to us. In our view, the more likely options to support the periphery are twofold. The ECB could clarify its reaction function on the reinvestments of its pandemic emergency purchase programme (PEPP), and later on, should this prove insufficient, it could create a new instrument to control spreads, even though this latter remains contentious in the Governing Council.

In this context, we remain very prudent on the European sovereign debt markets. In our view, euro area peripheral countries’ government bonds remain vulnerable, unless the ECB changes its mind fully as a result to the Russian invasion. In any case, investors are well advised to be prepared for a more “symmetrical” approach regarding monetary policy decisions.

Based on economic data, investors should be prepared to see central banks making decisions one way or the other, while adjustments have always been one-way on the dovish side in recent years. This situation should offer new investment opportunities for flexible and active managers.