By Bas van Geffen, Senior Macro Strategist at Rabobank

Price comes before the fall

Of course, the decline in Europe’s TTF gas price benchmark and the increase in gas storage over the Christmas holidays wasn’t only observed by this daily yesterday. French PM Borne stated that she is now more confident that energy supplies in the coming weeks will be sufficient. And a Dutch late night talk show discussed whether this meant that households would soon be seeing a drop in their utility bills again.

Certainly, such a drop in energy costs would be a welcome development for many Europeans. However, it also risks complacency. Firms have stopped certain production processes or have even shuttered entire plants due to the lack of availability and/or high costs of gas. Households have been looking for ways to self-ration as well, driven by concerns over the costs of electricity and gas use. Companies may be reluctant to reopen their production facilities as long as significant uncertainty over gas availability remains. But if consumers see energy prices decline again, that could easily make them complacent. And, worse, what if this lowers governments’ incentives –either on the national or EU level– to press on with structural improvements in Europe’s energy security? That could leave Europe more vulnerable next winter or in winters to come.

European equity markets extended their New Year’s gains and outperformed their US counterparts yesterday. Perhaps this resembles some of the optimism regarding the energy outlook, and a lower probability of forced rationing/blackouts in the near term. That said, it is too early after the holidays to draw much of a conclusion, and EUR’s underperformance compared to its G10 peers suggests that this may just be mere ex post rationalisation on our end as the continent’s outlook remains fragile.

In a sneak preview of the Eurozone inflation data released on Friday, German inflation dropped notably in December. HICP inflation slowed from 11.3% y/y to 9.6%; the lowest reading since August. That’s a softer than expected headline number, with markets anticipating a drop to 10.2%. Yet, as welcome as this stronger retreat to single-digit headline numbers is, the reading is affected by some unusual factors. Most importantly, the German government provided one-off compensation for energy bills last month. Meanwhile, prices of e.g. services have re-accelerated to 3.9%, in a sign that any retreat back to the ECB’s 2%-target may be a long process.

Supporting optimism about peak inflation, and perhaps casting some doubt over the ECB’s latest guidance that it will have continue to hike aggressively, French inflation came in significantly softer than expected as well. The country’s HICP declined to 6.7% from 7.1% in November. The French data show a similar trend as the German inflation figures; a slowdown in energy prices, while Insee notes that prices of services should accelerate, notably those of transport services.

Indeed, market-implied expectations of the ECB’s next few rate hikes have shifted marginally lower since the release of the data, with a cumulative 120bp of hikes priced by May, down from 126bp before the turn of the year.

That said, adding to the ECB’s concerns that it could take significant time before inflation returns to the central banks’ target, labour markets remain tight in various countries. Specifically, German unemployment unexpectedly fell in December. According to the Federal Labour Agency, there were 13,000 fewer unemployed after adjusting for seasonal factors and the inflow of Ukrainian refugees. With employment at a new high (latest data is for November), staff shortages continue to support employees’ bargaining power as they try to recoup some of the real incomes lost to high inflation.

Given the upside risks, it’s not surprising that the ECB’s hawks have not been muted by these recent inflation data. Kazaks repeated that he sees “significant” rate increases at the February and March meetings, after which “of course the steps may become smaller as necessary as we find the level appropriate to bring the inflation down to 2%.”

Elsewhere, China is still trying to cope with the surge in Covid infections after restrictions were eased. Some news outlets are reporting a potential peak in new infections, whereas reports of over-full hospitals and morgues paint a much bleaker picture. Some countries have already imposed inbound travel restrictions for passengers from China, and the EU will discuss a joint-policy today. 

The recent surge in Covid infections is not only straining the Chinese health care system. Bloomberg reports that it may now also stifle Beijing’s plans to kick-start a domestic semiconductor industry to compete with US-controlled supply chains. According to Bloomberg, the virus’ impact on the government’s budget forces government officials to reconsider its subsidies for the sector, which have been expensive and have yielded relatively few results.

It’s yet unclear what alternative policies the government may unveil but new strategies could include lowering the costs of materials, according to the news agency’s sources. This may slow the country’s path towards self-sufficiency in the chip sector, as it seeks to untangle itself from the US – which has increasingly been limiting its strategic rival’s access to key chip resources.