Europe’s recovery continues, but inflation remains too low.

Though the Eurozone’s economy continues to recover, the European Central Bank (ECB) is falling behind in achieving its price-stability objective, which justifies additional monetary stimulus, in our view.

Europe’s modest recovery has been resilient to the global economic slowdown—and we expect it to remain so, since Europe’s growth is, to a large extent, domestically driven, and the growth drivers have not changed much. The labor market has improved. Inflation is low thanks to declining oil and commodity prices, which have contributed to real incomes. Consumer confidence has risen, and the credit markets have strengthened. All these factors support private consumption, the key contributor to growth.

Additionally, Europe’s fiscal policy, which was a major headwind until 2015, turned mildly favorable to economic growth. Capital expenditures are not impressive, but nevertheless contribute to growth. Overall, in our view, the Eurozone is growing above its potential and gradually reducing its economic slack.

However, there are a few signs that growth has recently been losing momentum. Financial conditions have been tightening. And the inflation outlook continues to deteriorate (Exhibit 1), with the Flash Harmonized Index of Consumer Prices (HICP) falling back to negative territory (-0.2%) in February and core inflation declining to 0.7% in February from 0.9% in January.

Exhibit 1: The HICP and Core Inflation Have Fallen

Inflation expectations have come down as well, and are now around historical lows (Exhibit 2). While we haven’t yet seen a downturn in real sector data (as opposed to survey-based sentiment data), some forward-looking confidence indicators are declining. At this juncture, we believe policymakers need to act proactively to secure the twin objectives of economic recovery and risks-to-price stability.

Exhibit 2: Long-term Inflation Expectations in Europe Continue to Deteriorate

* A 5-year 5-year inflation swap rate reflects the market expectation of the average level of inflation over 5 years in 5 years from now.

Looking to the ECB

As the pivotal force behind Europe’s economic prospects, the ECB remains “the only game in town” and we maintain that it needs to act on March 10 to limit downside risks to growth, stability, and inflation. Up until now, its quantitative easing (QE) program—and other measures it took to stabilize and improve credit conditions—have been successful, and we believe the ECB will indeed act this week to curb the risks that have emerged.

We expect it to cut the deposit rate to -40 basis points, increase QE by 10 billion euro a month and also extend the duration of the program for another six months. Other dovish surprises may include expanding the pool of assets that are eligible for QE, such as corporate bonds. A number of ECB governing board members recently argued in favor of deeper negative rates, yet they acknowledged the market’s concerns, so we expect future ECB decisions to take these concerns into account.

Positioning Portfolios for European Corporate Credit

Our portfolios remain committed to buying corporate credit in Europe. As the ECB continues its QE program and financial conditions ease further with credit markets normalizing, we believe corporate credit should exhibit an attractive risk/reward profile. In addition, we find that the market’s inflation expectations are too low and tend to favor investments in inflation-linked bonds.

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