Euro area inflation rises to 3.8%: Inflation and tightening risks cap European equity upside

• Inflation is rising again, but its breadth remains limited. Neither core inflation nor wage growth has accelerated materially. Some companies are already facing cost pressures and raising prices, while further pass-through remains a risk.

• The European Central Bank (ECB) acts on the medium-term inflation outlook. Its projections incorporate indirect effects and some second-round effects, so policy need not wait until these effects fully materialise. Further action also depends on the impact of existing tightening.

• Financial conditions have tightened since the start of the year. Higher financing benchmarks constrain new borrowing and refinancing, and limit equity valuation expansion. Higher government bond yields also raise the return investors require to take equity risk.

• Current valuations and potential returns support maintaining our 2.0 Stars “Not Attractive” rating for Europe. Within Europe, we favour power infrastructure, defence and the artificial intelligence (AI) supply chain, where structural demand, policy support and multi-year orders provide greater visibility. Relative to Europe, we see Asia ex-Japan and emerging-market equities as more favourable.

Energy drives the inflation rebound, adding pressure to purchasing power

Eurostat's flash estimate, published on 2 October, showed that annual euro area Harmonised Index of Consumer Prices (HICP) inflation rose to 3.8% in September from 3.2% in August, exceeding market expectations of 3.6%. Energy inflation increased from 14.3% to 18.8%, making it the main driver of the acceleration.

Table 1: Energy drove the acceleration in euro area inflation in September 2026.

Annual inflation rate	August 2026	September 2026 flash estimate
All-items HICP	3.20%	3.80%
Core HICP, excluding energy, food, alcohol and tobacco	2.40%	2.50%
Energy	14.30%	18.80%
Services	3.00%	3.20%
Non-energy industrial goods	1.20%	1.10%
Food, alcohol and tobacco	1.10%	1.40%

Source: Eurostat, iFAST Compilations

Data as of 2 October 2026. September figures are flash estimates.

Energy pressures extend beyond petrol to natural gas, electricity and other household fuels. Wholesale prices feed into household bills through supply contracts and adjustments to retail prices, with transmission varying by energy category and market arrangements. A short-term decline in oil prices therefore may not immediately reduce household energy expenditure.

Higher energy bills leave households with less to spend elsewhere. Growth in compensation per employee slowed in the second quarter. If nominal income growth fails to keep pace with rising living costs, household purchasing power will face further pressure. Consumption data already show signs of strain. Annual retail sales volume growth slowed from 2.0% in May to 0.8% in August. Consumers' willingness to make major purchases has not improved materially, while their intention to save remains high. Persistently high energy prices could reinforce cautious spending behaviour.

Core inflation remains moderate, but cost pass-through is emerging

Core inflation rose from 2.4% in August to 2.5% in September 2026. Non-energy industrial goods inflation eased from 1.2% to 1.1%, while services inflation increased from 3.0% to 3.2%. These figures do not show a broad acceleration comparable with that in energy prices.

Wage developments help show whether higher energy prices are generating second-round effects that could make inflation more persistent. The ECB reported that annual compensation per employee growth slowed from 3.5% in Q1 2026 to 3.3% in Q2 2026. Annual unit labour cost growth also eased from 3.5% in Q1 2026 to 2.6% in Q2 2026. Wages have not yet shown a material response to the current energy shock.

However, the absence of a material wage response does not rule out inflation spreading through other channels. Higher input costs can pass through production chains before their full impact appears in consumer prices. On 30 September, ECB Executive Board member Isabel Schnabel highlighted rising import and producer prices, particularly for intermediate and capital goods. These provide early evidence of cost pass-through along production chains, which is not yet fully reflected in core inflation. Moderate core inflation and wage growth suggest price pressures have not yet spread widely across the economy, but that does not mean companies are unaffected.

Company disclosures provide concrete examples. Unilever PLC’s H1 2026 results, published on 28 July 2026, reported commodity-driven price increases in its Home Care business during Q2 2026. These were partly offset by the continuing impact of corrective pricing actions taken in Brazil in 2025. Its Personal Care business also expected price growth to increase in H2 2026 because of higher commodity costs. This suggests some input cost pressures are entering consumer goods pricing.

Cost pass-through is also occurring outside consumer goods. In their H1 2026 results, published on 30 July 2026, Schneider Electric SE reported a stronger pricing contribution in Q2, while Saint-Gobain, a French building-materials group, reported additional price increases as inflation picked up. Pricing contributed 1.6 percentage points to Saint-Gobain’s 3.5% like-for-like sales growth in Q2 2026. At Schneider, pricing gains only partly offset raw material and tariff costs, so the net pricing impact remained negative in H1. These disclosures suggest cost pressures are feeding into selling prices, although pass-through may be incomplete.

Tighter financial conditions constrain equity valuations

Rate expectations are already tightening financial conditions.

The ECB raised rates by 25 basis points in both June and September, taking the deposit facility rate to 2.5%. Its September projections show core inflation rising from 2.5% in 2026 to 2.6% in 2027, before easing to 2.3% in 2028, and already allow for some second-round effects. The ECB need not wait for wages to accelerate before acting, but further increases depend on how far existing tightening slows demand and inflation.

Further tightening is already reflected in market expectations. As of 1 October, euro area overnight index swap (OIS) pricing incorporated approximately one 25-basis-point rate increase by year-end. It also incorporated around 90 basis points of cumulative further tightening by September 2027, implying a deposit facility rate of approximately 3.4%. That is almost four 25-basis-point increases in total, including the one expected by year-end.

Policy expectations can tighten financial conditions through bond yields and loan pricing before rates are formally increased. The ECB noted that bank lending rates for firms rose from 3.6% in May 2026 to 3.8% in June and July 2026. As of 2 October 2026, the German ten-year government bond yield was approximately 3.45%, around 60 basis points above its end-2025 level. Higher borrowing costs gradually feed into corporate costs and demand as firms take out new loans and refinance debt. Even if the ECB pauses, the effects of existing tightening will not immediately disappear.

For equities, higher government bond yields raise the return investors require and tend to limit valuation expansion. The STOXX 600’s forecast FY2026 dividend yield of 3.16% now sits below the 3.45% German ten-year yield, so equities no longer offer an income premium over government bonds. However, markets have already priced in part of the expected ECB tightening, so not all of it is additional downside for share prices. We focus instead on whether policy exceeds those expectations, and whether companies can deliver current earnings forecasts despite higher energy and financing costs.

Maintain a cautious rating, favouring structural demand

European listed companies have demonstrated earnings resilience. Earnings for the STOXX Europe 600 Index grew 25.3% year on year in Q2 2026. Excluding Energy, earnings still rose 15.3%, indicating that the improvement extended beyond that sector. Overseas demand, cost management and changes in supply and demand in some industries supported index earnings.

However, the durability of growth differs by source. Recoveries in Energy, Materials and some Chemicals companies depend more on prices, low comparison bases and temporary changes in supply and demand. Strong near-term earnings should therefore not be extrapolated into sustained improvement across all industries.

We maintain our 2.0 Stars “Not Attractive” rating on European equities. Economic and earnings resilience is reflected in our existing forecasts, while inflation and financing risks remain unresolved. Applying a fair P/E multiple of 15 times gives a target index level of EUR 705. This represents approximately 12% price upside as of 9 October 2026, alongside an expected dividend yield above 3%. In our view, this potential return remains insufficient to compensate for the associated risks.

Within Europe, we continue to favour sectors including power infrastructure and defence. Data centre connections, upgrades to ageing grids and electrification support multi-year investment demand. Defence budget commitments and accumulated orders also support future revenue. In technology, we focus on ASML Holding N.V. (ASML) and Infineon Technologies AG (Infineon). They participate in AI infrastructure and technological upgrades through extreme ultraviolet (EUV) lithography equipment and power semiconductors, respectively. These companies still face input cost, financing and delivery risks, but their demand drivers are clearer than those of industries reliant on discretionary household spending.

On a relative basis, we favour Asia ex-Japan and emerging-market equities for their more compelling combination of earnings growth and valuation. Robust AI investment supports Asian semiconductor demand, while earnings growth is broadening into industrials, materials and other parts of the technology supply chain. Following the 3Q2026 correction, both markets’ forward P/E multiples stand more than one standard deviation below their respective 10-year averages, offering more attractive entry points while earnings momentum remains strong.

Table 2: These investment products provide exposure to our preferred markets and sectors.

Market / Sector	Investment Products
Power Infrastructure (includes European holdings such as Siemens Energy and Schneider Electric)	First Trust NASDAQ Clean Edge Smart Grid Infrastructure Index Fund (NASDAQ: GRID)
European Defence	WisdomTree Europe Defence UCITS ETF – EUR Acc (LSE: WDEF)
Emerging Markets	JPMorgan Funds – Emerging Markets Dividend A (mth) USD
	Vanguard FTSE Emerging Markets Index Fund ETF Shares (NYSE: VWO)
Asia ex-Japan	M&G (Lux) Asian A Acc USD
	Fidelity Asia Pacific Dividend A-USD
	iShares Core MSCI Asia ex Japan ETF (HKEX: 3010)

Table 3: Our forecasts imply around 12% price upside for the STOXX 600 by FY2028.

STOXX 600 Index	FY2025	FY2026E	FY2027E	FY2028E
PE Ratio (x)	17.7	15.6	14.5	13.4
Earnings Growth	0.28%	13.29%	7.41%	8.05%
EPS	35.75	40.5	43.5	47
Dividend Yield	3.01%	3.16%	3.44%	3.74%
Target Price (EUR) (Based on fair PE ratio of 15x)				705
Potential Upside (%)				12%

Source: Bloomberg Finance L.P., iFAST Estimates Data as of 9 October 2026