“The ECB has well prepared the market for the cut [ to 3.75%],” said Vincent Chailley, chief investment officer at H2O Asset Management, during an interview on 6 June 2024.

Questioned as. to whether the ECB may have made a policy mistake given that eurozone inflation ticked up to 2.6% in May from 2.4% in April, a level further away from the ECB’s 2% target, Chailley thinks that “the risk of higher inflation is modest in Europe.”

“US inflation is driven by demand… whereas it is driven by the offer in Europe,” stated Chailley during the interview. He explained that US demand is fed by the wealth effect from the strong performance of stock markets. “This makes the task of Fed more complicated. Should it reduce rates a bit too much, further demand will kick in, which may push inflation up again.”

“The theory on declining inflation on services is persistent”

Chailley thinks inflation in Europe is generally driven by the offer-side, i.e., price shocks on commodities fuelled by Russia’s war in Ukraine, while demand plays a little role and should not reappear “out of the blue.” As such, Europe is exposed to external shock not under the control of the ECB with its monetary policy having an impact on demand. Consequently, “the risk of rising inflation due to the ECB interest rate decisions are much smaller [than in the US].”

Yet the rise in inflation in May was due to services, a demand element and an issue also in the US and UK, which is bit more “challenging to contain.” Nevertheless, he thinks that the underlying trend is downward thanks to an easing of the labour market across advanced economies, a view shared by central bankers, he believes.

Further cuts on the way

During the entire interview, Chailley has expressed little wish to provide guidance levels on any indicator, focusing instead on trends. On ECB rates, further cuts should be expected. The reduction will depend on the extent of the economic slowdown, impacting inflation in return.

The central scenario at H2O is a deceleration of the eurozone economy that will avoid a serious recession this year and in 2025 as he does not see any “major imbalances in the economy… that may accelerate the recession.” He does not exclude a .

Delano asked Chailley whether it will be necessary to cut rates despite a reasonable growth in the eurozone and lower inflation figures so that the ECB maintains its firepower when rate cuts become necessary. “Not necessarily, but they will do it in Europe and in the US… as central banks have elected to be accommodative… despite rates being not so restrictive.”

With the situation more acute in the US than in Europe, Chailley suggested that “it is easier to manage a fast-increasing debt stack with lower refinancing rates… while accepting a bit more inflation,” as economies may outgrowth its debt. He thinks that the Fed may also become a bit more accommodative with some pressure from the Treasury department.

Weaker European currencies are expected

Chailley observed that exchange rates are set against an “interest rate hierarchy.” Higher interest rates will translate into a higher premium for a currency against other currencies. As the European bloc (Sweden, Switzerland and now the euro area) is cutting rates, he expects the premium for these currencies to decline.

Bonds as a risk tool

Asked by Delano on the direction of the 2-year (3.09%) and 10-year (3.02%) rates on French bonds, which are often considered as “core Europe,” Chailley commented he does not see any value in them nor in the US.

Currently, H2O only sees them relevant as a risk management tool. On the other hand, higher rates on government bonds are finally offering protective characteristics a feature that was lost for many years when rates were even negative. “We do not rely on them for performance but in times of high volatility, it is protective.”

European risky assets: “positive or positive”

“Either rates will not go down because of stronger growth… or the economy slows down and gives the freedom to the ECB to cut rates.” Therefore, Chailley sees both scenarios as supportive for the stock market.

Despite the recent rally in European stocks, Chailley claims that valuation remains very cheap compared to US markets. Moreover, he thinks that the potential for more rate cuts is attractive for investors. In addition, he estimated that dividends are almost three time as much as in the US, on average, largely because of the high valuation of the latter.

Besides, a culture of share buyback is appearing in Europe and has reached 5% of European market capitalisation. This is broad-based practice in the US which, for decades, has supported share valuation. Despite their recovery in the last years, Chailley remains positive on banks and auto, having added utilities recently as interest rates are heading lower.

Hard to finely balance investment in the energy sector and ESG

Chailley explained that the energy transition has a cost for society as it may generate inflation by moving from cheap fossil fuel to expensive clean solutions given their lack of scale. “Sometimes, a systematic underinvestment perversely results into higher valuation [for oil producers] on the back of higher oil prices.” H2O is overweighting the energy sector as it sees it as depressed despite offering a high return on investment.

He thinks that the “transition pressure” has passed its high point and that “Europeans have started to realise that too much pressure too fast becomes counterproductive as oil majors are considering moving their listing to the US.” He commented that coercion on these companies should lessen or stabilise.

Despite being a shareholder, H2O is not active “at all” in expressing its opinion through the voting process, according to Chailley. However, his firm accounts and monitors the ESG factors and has established a restriction list that avoids some sectors or companies.

Financial risk from Russia is limited

Chailley thinks that the Russian risk is sufficiently contained and does not necessitate any adjustment nor hedging. He argued that all the involved parties have no interest whatsoever in “extreme behaviours.”

This article was published for the Delano Finance newsletter, the weekly source for financial news in Luxembourg. .