Week ended July 22, 2022
ECB shocks, equities recover (until Friday)
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SUMMARY OF MARKETS
Didn’t see that coming! The ECB shattered its guidance (+25bps) and suddenly developed a backbone, increasing its three key overnight bank interest rates 50bps. This was the central bank’s first rate hike in 11 years, and it (finally) sent a message to investors that inflation was its top priority at the moment. The Euro had firmed earlier in the week ahead of the ECB announcement, recovering from its brush with Dollar parity. However, with the Italian government crumbling before our eyes, the Euro struggled to hold onto its gains, giving some of the improvement back albeit still managing to close better W-o-W (close $1.0213/€1.00). The ECB certainly has its hands full balancing full-on inflation, a war on its eastern flank, and government bond spreads widening in the periphery. Political turmoil in Italy isn’t helping. Isn’t it ironic that the “saviour” of the Euro 10 years ago – Mario Draghi – a former central banker with tremendous credibility, can’t maintain a working coalition in the Eurozone’s second most indebted nation? I am not going to regurgitate the issues that caused Mr Draghi’s coalition to collapse, but as someone grounded in economics, some of the assertions across the various parties are downright scary, at least as far as the future of the Euro. Which brings me to the political lay-of-the-land in the Conservative party in the U.K. It is true that the party has progressed as far as choosing a new leader to replace Boris Johnson, narrowing the field to Rishi Sunak and Liz Truss, with the latter seeming to have the edge. The process looks more orderly and less chaotic than the mess in Italy, but still, some parts of the economic platform (at least Ms Truss’s) make be shudder. This will all come to a head in early September, and then the saga can continue as I suspect there will be immediate rumblings calling for a snap election. Does the drama ever end? Let me turn back to Europe since I’m on a roll. The ECB now has to deal with the thorny issue of fragmentation, meaning the divergence of weaker Eurozone member bond yields from German bund yields. Of course, higher interest rates wouldn’t matter as much if the currency bloc had a combination of harmonious fiscal policy (to employ from time to time as a policy tool) and more alignment of relative fiscal strength of each of the Eurozone members. However, there is neither. The banking system also remains somewhat fragile. I think that there are simply too many banks in Europe. Unfortunately, nationalistic tendencies trump doing the right thing, which would be to “encourage” a series of cross border mergers to create five or six strong EU champion banks. As it stands, European banks are bloated and overstaffed (no comment on average quality of staff), so they simply can’t compete with the American / global investment banks even in their own backyard. In fact, the larger countries in Europe can’t even stomach merging their own domestic banks, so I can’t imagine a scenario where sensible cross-border mergers are encouraged to create EU national champions. This isn’t a revolutionary thought – it is just simple economics. That was a digression, so let me get back to something I know a bit more about - markets. Things were much better most of the week as risk sentiment improved. Unfortunately, yesterday was the polar opposite of the Friday before, with equities selling off to end the week although bonds rallied. There were arguably two culprits as far as equity weakness on Friday – select tech earnings and weak manufacturing data in the US and Europe. Earnings were fine most of the week, at least as far as getting through Netflix (NFLX) – a terrible disappointment in 1Q22 – and Tesla, which beat guidance across the board. However, the culprits for a dire Friday session were earnings from social media companies Snapchat (SNAP, –39% on Friday post-earnings) and Twitter (TWTR, flat but a different story altogether). Weaker-than-expected bottom line growth from both are inevitably a potential harbinger of earnings-to-come from other social media companies – like Alphabet/Google (GOOG, –5.8% on Friday) and Meta (Facebook, META, –7.6% on Friday) – which are also advertising-dependent. SNAP’s shocking miss reverberated throughout the tech market, with the NASDAQ paying the most severe price on Friday as it gave back some of its solid gains on the week although the tech-heavy index still finished 3.3% higher W-o-W. The good news is that all of the global and US equity indices I track were up for the week in spite of the ongoing news flow, and – with the exception of China and emerging markets – all are positive so far for July.
In other markets, government bonds rallied on Friday on weak economic news (read more in “Economic and Geopolitical News that Mattered this Week” below), with the yield on the 10y UST tumbling 27bps on Thursday and Friday. The yield on the 10y UST closed at 2.77%, its lowest level since May 30th. Corporate bond spreads followed suit, taking their cues from a better-bid equity market (until Friday at least). European high yield was the strongest performer as far as spread improvement amongst the corporate bond indices I track. Gold strengthened modestly. Oil and the US Dollar weakened. Bitcoin extended its recovery from its lows on July 2nd (see “Is the crypto winter over?” in E-MorningCoffee), as the crypto ecosystem showed signs of stabilising after a tumultuous few months.
It is almost a sure thing that a recession is coming in the UK and Eurozone, but I also feel reasonably confident that a recession is coming Stateside and that the worst as far as inflation might be behind us. Here are the reasons:
Slowing job market (payrolls growth decreasing) generally, as well as slowing / temporary halts in new hires at firms like Apple and Microsoft and declining advertising / marketing spend (based on recent results from SNAP and TWTR)
Lower intermediate / long term yields
Inverted yield curve
Oil is showing signs of “demand fatigue” in spite of Russian war disruption
Polls showing declining consumer confidence
PMI declines in manufacturing and services in the US in June (and in the UK and Eurozone)
Uncertainties regarding the Chinese economy – the world’s second largest – especially with respect to periodic COVID-shutdowns and a fragile property sector
Fed will continue raising rates, making it crystal-clear that its priority is inflation at the expense of a slowing economy / rising unemployment
Equities stabilising, meaning they might be looking through to post-recession (and don’t underestimate the forward predictive power of the stock market)
ECONOMIC AND GEOPOLITICAL NEWS THAT MATTERED THIS WEEK
CPI rockets in UK and Eurozone, inflation on steroids
Old news and more of the same as CPI in the UK increased to 9.4% (YoY) in June from 9.1% in May. The BoE has forecast as much, so this was no surprise. The ONS release regarding UK inflation for June is here. CPI in the Eurozone increased from 8.1% in May to 8.6% YoY in June – see Eurostat release here.
ECB shocks with 50bps increase in overnight bank borrowing / deposit rate
Although the ECB “leaked” the potential for a 50bps increased in its three key interest rates (including the overnight bank borrowing and deposit rates) a couple days before it announced the change, most economists and investors felt an increase of this magnitude was unlikely, with 25bps being the base assumption. In retrospect, it is not clear that the ECB had a lot of choice but to go big given rapidly rising inflation in the Eurozone and the fact that it is trailing its peers in the US and UK as far as tightening monetary policy. This is the first time that the Eurozone short term rate has not been negative since 2012, although keep in mind that the rate is not quite positive either at 0%. The ECB is chasing the Fed and BoE, both substantially ahead in their tightening regiment. The ECB press release announcing the change in policy is here.
The ECB press release also mentions the Transmission Protection Instrument (TIPs), which is the anticipated policy of the ECB to aid countries that are seeing their bond yields widen significantly more than benchmark German bund yields. I presume the mechanism is to buy the bonds of peripheral countries that are facing widening because of the ECB’s policy of raising interest rates to combat inflation. I found the description of the TIPs programme a bit squishy and can’t help but wonder if a country like Italy, which might well be on a course of self-mutilation, deserves such support. I suppose that is not for an amateur like me to answer, but it just doesn’t feel right.
Italy in chaos, Conservatives narrow next PM to two
The resignation of Mario Draghi and the confusion it has brought on the Italian government and its leadership is unfortunate, and I would not pretend to know what other Italian parties are thinking as they unravel credible leadership in which the the Eurozone and the world had tremendous confidence. The damage this might do remains to be seen, but I do not see it as positive in any respect. In the UK, the list of potential candidates from the Conservative party to replace Boris Johnson is whittled down to two – Rishi Sunak and Liz Truss, with the latter the favourite. This has been covered everywhere by mainstream media, but here is a “policy guide” which is decent from the BBC. The 200,000 or so UK Conservative party members will vote on their next leader in early September, with Ms Truss seeming to have the edge at the moment.
PMI declines in the US, UK and Eurozone
S&P Global released flash Purchasing Managers’ Index (“PMI”) for the US, UK and Eurozone on Friday, and all three economies indicated declines in manufacturing and services in June. US Composite PMI Output (here) was the lowest in 26 months, and the UK (here) and Eurozone (here) had the slowest PMI growth in 17 months. Both the UK and Eurozone PMI data pointed towards some softening in input prices although end prices remain significantly elevated vis-à-vis historical levels.
US first time unemployment claims increase again
First time unemployment claims increased for the third consecutive week according to data released (here) by the US DoL on Friday. This is indicative of a slowing jobs market in the US, albeit the weekly increases seem relatively mild to me.
S&P 500 earnings
In 1Q2022, horrific earnings by Netflix were the start of a difficult and very mixed quarter for many US technology companies, splattering the entire market and leading to what would be the worst first half performance for equities in decades. Netflix’s 2Q2022 earnings, released Tuesday after the close, were fortunately better than consensus this time, and this cheered the market. Tesla also delivered solid results on Wednesday after the close. However, Snapchat (SNAP) badly disappointed on Thursday after the close, with the stock being punished on Friday along with other technology / social media companies that are advertising-dependent. The always reliable weekly earnings report from Lipper/ Refinitiv for the week ended July 22, 2022 can be found here. In spite of SNAP, more-than-the-average number of S&P 500 companies (106 have reported so far) have reported better-than-consensus top- and bottom-line growth for this quarter.
Here is some of the key data and dates on which to focus.
The FOMC is July 26th-27th. Consensus is for another 75bps increase in the Federal Funds rate, which will be announced Weds (27th) along with a policy statement, and this will be followed by a press conference with Mr Powell
172 more S&P 500 companies report earnings this coming week (week of July 25th), including all five FAMAG companies: GOOG 7/25; MSFT 7/26; META (Facebook) 7/27; and AAPL and AMZN 7/28. Also this week, we have: MCD, V, KO, KMB, GM and GE (Tues); ETSY, SHOP, QCOM, SPOT, BA (Weds); MO, INTC, MA, MRK, ROKU, LUV (Thurs); and CVX, CL, XOM and PG (Friday).
The US and Eurozone release 2Q2022 GDP on Wednesday and Friday, respectively
Consumer confidence, durable goods and housing data for June is released for the US on Tuesday and Wednesday
PCE – the inflation indicator monitored most closely by the Fed – is released on Friday
Corporate bonds (credit)
Safe haven and other assets
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