Markets pause as Italian political mess keeps pressure on ECB and were earnings misses really that bad?
Stock markets across Europe are higher at the end of the week, with the biggest winners being the Dax, the FTSE 100 and the Italia Borsa, all up more than 1% at the time of writing, which is helping the indices to recoup losses after a torrid week. Even with Friday’s gains, the risk factors afflicting markets right now seem to be piling up: Italian political instability, Chinese economic growth, Covid infections on the rise and some key Q2 earnings misses in the US. Futures markets in the US are also pointing to a higher open, with the S&P 500 expected to open up more than 0.4%. Although US indices ended the day lower on Thursday, they closed well off their lows. Trading right now seems like risk limitation, with the bulls given very few opportunities to buy the dip when it comes to equities, but today might see a short-term shift in sentiment.
The benefits of the Fed lifting rates by 100bps
Higher than expected US CPI has raised the chances of a 100bp rate hike from the Federal Reserve when they meet on 27th July. There is now a 52.3% chance of a 100bp rate hike. This is a huge move, but would a large rate hike actually be better for risk sentiment in the long term, if it cooled the economy and helped bring down the CPI rate in a shorter time period? The increase in core CPI, which is more important to the Fed, was broad-based last month, with shelter, new cars, used cars, medical care and vehicle insurance all experiencing the largest monthly increases. Due to this, and the fact that demand for shelter and cars is sensitive to interest rate changes, it makes sense for the Fed to go with a big rate hike to stump out inflation growth.
Is inflation finally peaking in the US?
However, there are signs that inflation could be nearing a top, even if that top is a lot higher than anyone thought earlier this year. Headline PPI for June came in stronger than expected, however, the core rate of PPI was slightly weaker than expected at 0.4%, the lowest monthly increase since April, and weaker than the 0.6% increase for May. Initial jobless claims were also at their highest level since November. This has led to some Fed members now leaning towards a 75bp rate hike, with both Bullard and Waller, two of the most Bullish members of the Fed, who said that the market had got ahead of itself in recent speeches. However, until inflation does cool then we are in a stagflation phase, which is the most painful stage of this economic cycle. Hence, the volatility and continued sell off in financial markets could be here for some time yet. We have mentioned that bear markets last on average 9 months, which could mean that the current market sell off lasts throughout the rest of the summer until October.
Unpacking Italian political turmoil
As we move through the summer, the focus will now shift to the July Fed meeting. Elsewhere, Italian political turmoil has taken another turn, this time the President has refused to accept Prime Minister Mario Draghi’s resignation, which has been welcomed by the market. Italian bond yields are down 5 basis points today, and the Italia Borsa is one of the best performing indices in Europe so far on Friday. It is worth pointing out that the situation in Italy remains precarious. While the ECB has been at pains this week to say that its anti-fragmentation plan to help the weaker states as their debt costs vs. Germany soar, will not come with erroneous conditions, Italian debt is still flashing red warning signals. Italian financial stress comes at the same time as Germany is running a deficit and may not be able or willing to support their southern neighbours, compared to 2013. This is one reason why the Italian – German 10-year yield spread hit the highest level for a month before falling back a touch on Friday. The ECB tends to get nervous when the spread reaches 2.25-2.5%, currently the spread is 2.1%. Some background on the current drama going on in Rome: Italy’s government collapsed when the Five Star Party refused to back a EUR 26bn cost of living package. Although the plan was comfortably passed by Parliament, PM Draghi had said that he would only stay in position if he had the broad support of all the parties. The risk is that a new election would be negative for Italian bond yields, it would also render the ECB’s anti-fragmentation tool useless for Italy if its bond yields were rising on the back of domestic political pressure.
As we end the week, Italy looks like Europe’s weakest link, in a historic week for the currency bloc, when EUR/USD reached parity, this FX move has many ramifications for the currency bloc, not least the prospect of more prolonged inflation and economic pain as the ECB fights many fires at once.
Q2 earnings downgrades incoming
We will update you on Q2 earnings in more detail next week, however, it is worth pointing out that US banks have generally missed expectations. A weaker set of earnings and news that it was suspending its dividend spooked investors this week. JP Morgan’s stock price declined more than 3.4% on Thursday. While JP Morgan may have missed estimates for EPS and revenue, it did post some solid commentary on consumer and business credit, which may protect its share price from falling much further in the short term. Unlike other economic contractions, we are not witnessing a massive jump in defaults in the US, which is another sign that this economic cycle is different.
Overall, the market sentiment remains perilous and sensitive to external news. Looking to next week, we can’t see many drivers that could trigger a long-term switch to a more optimistic outlook for risk. The dollar is still king in our view, and it is likely to remain this way if we see another wave of downward estimates for Q2 earnings in the coming days.