Financial conditions are tightening, with the ECB raising its policy rates for the first time since 2011. We expect the US Federal Reserve to raise the federal funds rate by 0.75% at its meeting on 26-27 July. In this environment, investors’ eyes are on corporate earnings for the second quarter.
2Q earnings season underway
Amid what the latest survey of institutional investors run by Bank of America described as a ‘dire level of investor pessimism’, the 2Q reporting season has begun.
Earnings reports have been the main driver of the equity market this week, with relatively little economic data having been published. With only 7% of companies reporting, it is still early days.
Despite the poor sentiment, it seems the market has tended to interpret the results with a glass half full mentality. The S&P 500 index has rallied by 4.16% over the last five days.
Hope springs eternal with investors, who are hoping that company earnings will hold up and that the Federal Reserve will refrain from very aggressive monetary tightening. Hence, perhaps, the more positive tone in a market positioned for bad news.
The number of companies reporting earnings will reach a peak in the week starting 25 July, when around 200 companies in both the STOXX 600 and S&P 500 are due to report.
FOMC meets on 26-27 July
Federal Reserve officials, speaking after the stronger-than-expected data for US consumer prices in June – a 9.1% rise in US inflation over the last year, its highest level since 1981 – have still generally guided towards a 75bp rise in the federal funds rate at next week’s meeting of the Federal Open Markets Committee (FOMC) on 26-27 July. Albeit with some contingency on the upcoming data.
The data for retail sales in the US in June came in modestly above analyst expectations (accounting for prior month revisions, control group sales were 0.20% stronger than consensus).
On the inflation front, the University of Michigan preliminary survey showed US consumers seeing inflation running at 2.8% over a five-year horizon (below consensus expectations of 3.0%). The reading is the lowest in a year and down from 3.1% in June.
This was a meaningful decline, unwinding all of the gains in expectations over the past year. It perhaps underscores how much US households are forming their inflation expectations based on petrol prices. This downside surprise strengthens the case for a 75bp July rate rise, in our view.
First ECB rate rise since 2011
The European Central Bank (ECB) raised policy rates for the first time since 2011 at its recent meeting. The 50 bp hike was more than expected and boosted the euro, which in recent days had weakened to almost parity versus the US dollar (see Exhibit 1 below).
In a press release, the ECB said that it had judged it appropriate to take a larger first step on its policy rate normalisation path than previously signalled because of higher-than-expected inflation and the need to support its new bond-buying scheme.
The ECB’s deposit rate will rise from minus 0.5 % to zero, while the rate on its main refinancing operations will rise from zero to 0.50% and its marginal lending facility will increase from 0.25% to 0.75%.
This rise in policy rates comes at an awkward juncture. Italian Prime Minister Mario Draghi has resigned, ending a national unity government formed to tackle unpopular reforms and creating a vacuum at a time of significant economic challenges. President Sergio Mattarella is now expected to dissolve parliament and announce snap elections.
Draghi’s resignation has fuelled a sell-off in Italian debt, with the yield on Italy’s 10-year government bond rising by 22bp to 3.6%. This move took the spread between Italian and German benchmark yields to 2.33%, reflecting an increase of around 30bp over the last two days.
Transmission Protection Mechanism
As expected, the ECB announced its new anti-fragmentation tool at today’s meeting, which will be employed to limit the divergence between the borrowing costs of eurozone member states.
It is likely that financial markets will now seek more detail on how this tool will be employed. The more powerful and credible the tool is, the lower the probability the ECB will have to use it.
Keeping spreads in check allows the ECB to deliver the appropriate degree of accommodation for the whole eurozone, while keeping a homogeneous transmission of its monetary policy.
According to Bloomberg, Russia’s President Vladimir Putin signalled on 20 July that Europe will start getting gas again through the Nord Stream 1 pipeline after maintenance ends on 21 July. However, flows would at best return to 40% of the capacity that prevailed until 11 July. This could drop to just 20% at the end of July unless a dispute over sanctioned parts is resolved.
Gas inventories have remained broadly flat in Germany and in the European Union (levels are around 64%). While it seems unlikely that we will see a return to pre-war or even May levels of gas exports from Russia to the EU, an increase in gas exports above levels seen in recent weeks now looks probable.
The ongoing uncertainty over gas supplies is damaging Europe’s economic outlook. The uncertainty itself affects corporate investment and hiring intentions, while higher energy prices are reducing households’ purchasing power.
We expect growth in the eurozone to remain weak until the middle of 2023 due to:
1. A squeeze in disposable income from high inflation
2. Ongoing shocks
3. Weaker global demand
4. Weaker trade
5. Tighter financial conditions.
A stoppage of gas flows would, in our view, trigger a fully-fledged recession.
What to watch out for next week
Apart from the earnings season and the meeting of the FOMC, next week will see release on 28 July of the advance estimate of US GDP growth in 2Q 2022.
If the data shows negative growth (we do not expect it will), it would mean the US slid into recession in the first half of 2022 (based on the definition, generally employed in Europe, whereby two consecutive quarters of negative growth constitute a recession).
In the US, however, a committee within the National Bureau of Economic Research (NBER) makes the call as to whether the economy is in recession based on a variety of indicators. The NBER’s traditional definition of a recession is that it is:
“a period of sufficient broad-based weakness in economic activity that results in a marked deterioration in the labour market, typically necessitating a meaningful economic policy response.”
Even if US GDP data should show negative growth in each quarter during the first half of 2022, it is highly unlikely that the NBER committee will announce a recession. This year, the economy has been creating over 300 000 jobs per month. This is not the hallmark of an economy in recession.
In addition, the 2Q GDP data will be subject to revision and revisions are often substantial. Consequently, the NBER committee tends to wait, on average, for almost a year before calling turning points in the US economic cycle.
In our view, high inflation will require a significant rise in US policy rates. Fiscal policy will be a drag and global financial conditions are tightening. As a result, we would expect unemployment to begin to rise in the second half of 2023 with a mild recession similar to the 2001 experience.