(Bloomberg) -- China’s reopening and an ebbing energy crisis are expected to give Europe's economy a boost this year, helping it avoid a recession, the latest MLIV Pulse survey shows.

A series of rate hikes by the European Central Bank aimed at taming the region’s  inflation, however, are expected to tarnish the appeal of the region’s debt. The ECB’s deposit rate will top 3.5% after another 1.5 percentage points of hikes, according to more than a third of 201 respondents in the poll. An additional 15% see it heading to 4% or above, which would be a record level.

That helps explain the survey participants’ strong conviction that euro area bonds will underperform US Treasuries this year.

The Federal Reserve “seems closer to ending the cycle than the ECB” and there’s also “greater uncertainty” over where euro-area rates peak, said Rohan Khanna, rates strategist at UBS Group AG. With possible Fed cuts later this year and a wave of supply from European governments, the outperformance of Treasuries versus bunds is one of his top trades.

Goldman Sachs Group Inc. economists now expect the euro-zone’s gross domestic product to grow 0.6% in 2023, compared with their earlier forecast of a recession and overall decline of 0.1%. 

European stocks edged higher on Monday, with German and French shares outperforming. The euro ticked lower versus the dollar and front-month European gas forwards extended declines.

China’s sudden reboot has given economists a strong reason to revise expectations. European luxury behemoths including LVMH and Gucci owner Kering SA are seen benefiting in particular as wealthy Chinese consumers start shopping and traveling again after heavy restrictions under Beijing’s Covid Zero policy. 

 About one-third of survey respondents said luxury and other discretionary sectors would benefit most from China’s re-opening, while another 23% said tourism and travel. The MSCI Europe Textiles Apparel & Luxury Goods Index has gained twice as much as Stoxx 600 so far this year. Luxury stock price levels are trading above analysts’ targets.

European stocks in the fourth quarter had their best-ever run relative to US peers in dollar terms; that notable outperformance has continued into 2023. Relatively cheap valuations helped. The Stoxx Europe 600 Index trades at a 12-month forward price-to-earnings ratio of over 12 times, compared with the S&P 500 at about 17. US stocks’ premium is historically pricey.

The survey also showed that most investors expect Europe to avoid an energy crisis in 2023. Mild weather has seen the price of natural gas plummet as fuel consumption drops, and stockpiles are fuller than usual for this time of the year. More than 60% of MLIV survey participants predicted an energy crisis can now be avoided.

Yet, policy makers have been warning that their fight against inflation is still ongoing. ECB Governing Council Members Olli Rehn and Pablo Hernandez de Cos are the latest to say there are still “significant” rate rises ahead. 

The area’s core measure of inflation, which strips out food and energy, rose to a record high of 5.2% in December even as the headline figure declined to 9.2%.

Market bets on the ECB’s peak rate have slipped in recent days, falling back below 3.5% for July. More than half of survey respondents, however, see the rate not peaking until the third quarter or later. 

Meanwhile, in the US, slowing inflation is fueling expectations that the Fed is about to rein in its aggressive cycle of hikes. Markets are now leaning toward a 25 basis points increase come February, which would be the smallest in nearly a year. Jupiter Asset Management sees 10-year Treasury yields slumping as low as 2%, compared to around 3.40% now, as a global downturn pushes investors toward haven assets.

Blowout Risk

The expectation of further significant ECB tightening helps explain another response to the MLIV survey: about 72% of investors think it’s very likely or somewhat likely that the central bank will have to use its Transmission Protection Instrument, a bond-buying tool to mitigate financial stress. 

Contrast that to comments by ECB officials, who have said they hope the TPI won’t be used and that its existence alone will be enough to avert unwarranted selloffs in the region’s riskier sovereign bonds. 

“I think there’s a non-trivial probability TPI will be used, if you think about raising rates and the massive supply coming,” said Greg Peters, co-chief investment officer at PGIM Fixed Income. “They can’t afford to have Italian spreads blow out.”

A continued hawkish stance from the ECB could derail gains in German debt so far this year and lift 10-year yields close to 3% this quarter, from around 2.2% currently, according to Societe Generale SA strategists. As a result, more than three quarters of those surveyed favored Treasuries over euro-area bonds this year. 

While both US stocks and Treasuries are on a roll so far in January, a majority of professional and retail investors think those holding bonds will end up with better returns in the next month. The longer-term outlook for equities also looks tough, according to Marija Veitmane, senior multi-asset strategist at State Street.

“The current state of the US economy is reasonably strong and that’s creating inflationary pressure,” she said in an interview with Bloomberg TV on Friday. “The Fed will have to stay fairly aggressive for longer, with no cuts, and that means deeper recession later on. In that world, you prefer bonds over stocks.” 

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--With assistance from Simon White, Heather Burke, Alicia Diaz and Tomoko Yamazaki.

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