European markets closed off the year with a modest loss in December, largely due to concerns over the weak economy in the region as well as the monetary policy outlook. The Euro also gained 2.87% against the Dollar on the back of a more hawkish ECB. Over the month of December, the STOXX 600 Index lost 3.44% (up 0.26% in US$ terms).

The latest economic data in Europe showed slight improvement. PMIs surpassed expectations and improved MoM, although they remained in contraction; confidence indices rebounded; CPI data also suggested that inflation in the region has peaked, but the figures are still far from the ECB’s long term target level. The ECB hiked rates by a meagre 50 bps in the December meeting, but ECB President Chirstine Lagarde suggested that 50 bps hikes will be the new normal, and more hikes are on the way to get inflation under control, the ECB will also start to trim its inflated balance sheet. At the time of writing, markets are pricing in another 150 bps in rate hikes within the year. 

The confirmation of monetary policy tightening will put further pressure onto the valuation levels in the market, as well as the economy itself. Upside in the equity market will be relatively limited, and the material risks of recession could drive corporate earnings lower. However, these factors have yet to be properly priced into the market, we see more downside risks in European equities. Thus, moving on into the New Year, before the risks are priced in sufficiently, we continue to advocate underweighting European equities.