Prospect of further ECB rate hikes reinforces our downgrade of European equities

• The ECB raised its deposit rate by 25 basis points to 2.25%, while cutting its 2026 growth forecast to 0.8% and raising its inflation forecast to 3.0%.

• Unlike in 2022, the current energy shock is hitting an economy with limited cyclical buffer, as services activity has already moved into contraction.

• Higher rates constrain valuation expansion and add pressure to household spending, corporate investment and credit demand.

• We maintain our Unattractive rating on European equities, while favouring European defence and global power infrastructure and electrification.

The European Central Bank raised its deposit facility rate by 25 basis points to 2.25% on 11 June, marking its first rate increase since 2023. The decision reflects the renewed inflationary pressure created by the Middle East energy shock and the continued risk that higher energy costs spread into core prices.

At the same time, the ECB lowered its 2026 growth forecast to 0.8% and raised its inflation forecast to 3.0% — a combination that is closely aligned with the rationale behind our downgrade.

The rate increase itself was broadly expected. For investors, the more important message is the macroeconomic environment it confirms: the ECB is tightening policy while economic momentum is weakening.

This is the rate environment we warned about

When we downgraded European equities from Attractive to Neutral in March, one of our core concerns was that the low-rate environment supporting Europe’s recovery narrative was beginning to reverse.

At the time, the ECB was still emerging from an easing cycle, and markets broadly expected further monetary accommodation through 2026. However, the renewed energy shock has pushed inflation higher and materially changed the policy direction. The ECB is no longer cutting rates; it has returned to tightening.

More importantly, this rate increase comes as economic momentum is already weakening. The eurozone composite PMI fell to 48.5 in May, with services activity moving into contraction. First-quarter GDP was revised down to a 0.2% quarter-on-quarter contraction, although this was largely driven by volatility in Irish multinational activity. Consumer confidence also remains well below its long-term average.

Tighter monetary policy alongside weaker economic activity is the central risk behind our further downgrade of European equities to Unattractive. The June rate increase has not created a new problem; it has confirmed the policy dilemma we had already identified.

The economy has less buffer than in 2022

When the Ukraine conflict began in 2022, Europe was still in a post-pandemic reopening expansion. Before the invasion, the eurozone services PMI was already above 55 and continued to strengthen in the following months, as travel, leisure and other face-to-face services benefited from reopening demand. This provided a meaningful buffer against the initial energy shock.

The starting point in 2026 is very different. Before the Middle East conflict escalated, Europe was only experiencing a tentative and uneven recovery. The composite PMI remained slightly above 50 between January and March, but slipped back into contraction in April and May, with services becoming the main drag.

This means a similar type of energy shock is now hitting an economy with a much weaker domestic-demand cushion.

The ECB also acknowledged that the conflict and higher energy prices are weighing on activity, with survey data pointing to particularly weak services momentum. Nevertheless, inflation risks have forced the ECB to prioritise price stability.

This leaves Europe facing a clearer stagflationary policy dilemma. Monetary policy cannot increase oil supply or repair logistics bottlenecks, but the ECB must still tighten financial conditions to prevent energy inflation from spreading into services prices, wages and inflation expectations.

For European equities, this combination limits valuation expansion and increases the financial pressure on households and businesses.

A further July hike remains a risk

The ECB continues to emphasise a data-dependent, meeting-by-meeting approach. A further rate increase in July is therefore not predetermined, but it remains a credible risk.

Services inflation reaccelerated to 3.5% in May, while inventories, supply contracts and corporate hedging arrangements may still be delaying the full pass-through of higher energy costs to consumer prices. This suggests that conditions are not yet in place for a rapid return to monetary easing.

However, a further weakening in economic activity would also constrain the ECB’s ability to continue tightening. The policy path will therefore depend on the balance between energy prices, core and services inflation, and the extent of the growth slowdown.

What it means for European equities

Three transmission channels are particularly important.

Valuation expansion becomes more difficult

Higher interest rates increase the discount rate applied to future earnings and place pressure on valuation multiples.

The STOXX 600 is currently trading at around 16 times 2026 forward earnings. This valuation partly assumes that inflation will ease, monetary policy will gradually normalise and earnings growth will recover.

The ECB’s latest forecasts suggest that inflation may take longer to normalise than markets previously expected. If rates remain higher for longer, the scope for further valuation expansion will be limited.

Household finances face additional pressure

European households are facing a combination of higher energy costs, elevated borrowing costs and weaker employment expectations.

Consumer confidence remains subdued, while the contraction in services PMI indicates that household spending and domestic demand are already under pressure. This is likely to affect retail, travel, restaurants, leisure and other domestically oriented service industries.

At the index level, earnings from energy, defence and selected global exporters continue to provide support. However, this may be masking greater pressure among companies more exposed to European domestic demand.

Corporate financing conditions are tightening

Higher interest rates increase financing costs for small and medium-sized enterprises and domestically exposed industrial companies, particularly those without access to bond markets or diversified overseas revenue.

The ECB’s latest Bank Lending Survey already shows tighter credit standards, weaker corporate loan demand due to reduced fixed-investment needs and a marked decline in consumer credit demand.

The latest rate increase may reinforce this existing tightening trend, particularly for capital expenditure, durable-goods consumption and interest-rate-sensitive borrowers.

Preferred sectors: focus on visible fiscal support and earnings visibility

A downgrade of the broad European market does not mean that Europe lacks investment opportunities. In a weaker growth environment, we prefer sectors where demand is supported by government budgets, regulated capital expenditure and multi-year order books, rather than by household consumption, private investment or a broad cyclical recovery.

Germany provides a clear example of this divergence. Government fixed-capital formation has accelerated, while private fixed investment remains weak. This suggests that the improvement in parts of the economy is being driven primarily by public spending rather than a broad-based private-sector recovery.

The most direct beneficiaries include defence, construction and engineering, grid equipment, electrification, capital goods and selected industrial automation companies.

We therefore continue to favour European defence, together with power infrastructure and electrification.

Defence: fiscal commitments and backlogs support revenue visibility

European defence continues to benefit from rising military expenditure, inventory replenishment and efforts to strengthen domestic defence capacity. Demand is supported by government budgets and multi-year procurement programmes, making the sector less dependent on near-term consumer demand and private investment.

The Middle East conflict has further reinforced the urgency of strategic autonomy and faster defence spending. At the same time, backlogs across major defence companies remain elevated, supporting revenue and earnings visibility over the coming years.

Although valuations have rerated substantially, the structural investment case remains supported by firm spending commitments, order growth and continued earnings delivery.

Investors looking to gain exposure may consider the WisdomTree Europe Defence UCITS ETF - EUR Acc (LSE: WDEF).

Related Article: European Defence: Backlog growth supports a multi-year earnings cycle

Power infrastructure and electrification: three drivers support long-term capex

We also remain positive on power infrastructure, supported by three structural drivers.

AI data centres are accelerating investment in power supply, cooling systems and grid connections. The electrification of transport, buildings and industry provides a separate, long-term source of electricity demand. Meanwhile, concerns over energy security have made resilient domestic power grids a higher policy priority.

Together, these trends support sustained spending across electrical equipment, transmission and distribution networks, cables, substations, grid automation and regulated utilities. Compared with cyclical industries that depend on a broad economic recovery, these areas benefit from clearer demand, longer project cycles and stronger earnings visibility.

Investors looking to gain exposure may consider The First Trust NASDAQ Clean Edge Smart Grid Infrastructure Index Fund (NASDAQ: GRID).

Related Article: The energy security trade the market has not priced yet

Rating maintained: Unattractive

The ECB’s rate increase, and the risk of further tightening, reinforces the central investment argument behind our downgrade.

The low-rate environment that previously supported European equities has reversed. The ECB is tightening monetary policy while growth weakens, in response to an energy supply shock that monetary policy is unlikely to directly resolve.

Its latest forecasts suggest that inflation may decline only gradually, while growth risks remain tilted to the downside. This means that the improvement in financing conditions, valuation expansion and earnings recovery currently expected by the market may take longer to materialise.

We therefore maintain our Unattractive rating on European equities.

Within Europe, we continue to favour areas with visible fiscal support and strong order visibility, particularly defence. We also remain positive on power infrastructure and electrification. We remain cautious on broad market exposure and sectors that rely heavily on European domestic consumption and private investment.

The next important test will be the second-quarter earnings season in July and August. This will provide the first more complete assessment of how the Middle East conflict is affecting corporate costs, demand and profit margins.

Declaration

For specific disclosure, at the time of publication of this report, IFPL, through its connected and associated entities, and the analyst who produced this report hold a NIL position in the abovementioned securities.

This research report was prepared with the assistance of artificial intelligence tools. iFAST Financial Pte Ltd does not rely exclusively on AI for content generation. The content of this report, including all investment theses, ratings, price targets and conclusions, has been independently reviewed and verified by the research analyst(s) to ensure accuracy and professional integrity.

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