European equities have rallied strongly in recent months.

We are now over 12 months on from the commodity price jumps that followed Russia’s invasion of Ukraine. Due to this there was a big drop in European headline inflation from 8.5% to 6.9% in March. European inflation has lagged US inflation but eventually pushed above US inflation due to firstly, the strength of the US$ which increased imported inflation into Europe and secondly, the rise in European natural gas prices. Both factors have reversed recently; hence the headline rate of European inflation should fall below that of the US as 2023 unfolds. Inflation in the Eurozone is now an average of 7% and the US is at 4.9%.

European headline inflation is expected to fall but Core inflation seems to be more stubborn. The ECB will want to see the decline in core inflation before reducing interest rates. Hence the view that The ECB will keep interest rates higher for longer than the Fed might.

The ECB met in early May and increased rates by 0.25% to bring the headline interest rate to 3.75%. This change represents a down-shift from the larger increases that the central bank had been making so far in this hiking cycle.

The ECB is further behind in its hiking cycle relative to both the Federal Reserve and the Bank of England. May’s smaller 0.25% move represents a recognition that the end of rate rises is in sight.

Two elements will have weighed on the ECB’s decision. First, although inflation is still high, the General Council will have been encouraged by April’s inflation report, which showed core inflation decelerated to 5.6% from 5.7% in March, helped by good prices. The report did not include any unpleasant upside surprises, which might have persuaded GC members to opt for a bigger increase today.

Second, credit conditions. The ECB’s quarterly Bank Lending Survey showed that both demand and supply of credit is waning in the eurozone. This will act as a brake on economic activity, and therefore inflation, removing some of the need for monetary policy to do the job. In the US, the Federal Reserve has made a similar calculation, following regional bank failures. Europe likely has a greater sensitivity to this, because European commercial banks provide a greater proportion of lending in the economy compared to the US, which has more developed capital markets.

European equities have rallied strongly in recent months as the continent made it through the winter by mild weather, lower energy demand and falling wholesale gas prices. The EuroStoxx 50 index is up 14.7% year to date to May.

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